What if Your Employer Drops its 401(k) Match?

What do FedEx, General Motors, Frontier Airlines, Eastman Kodak, Motorola, Sears and Unisys all have in common? All have announced plans to cut costs by suspending their matching contributions to employee 401(k) plans. Even Starbucks has announced that it may drop its 401(k) match in 2009.

Employee benefits firm Watson Wyatt Worldwide reported the results of a survey that asked companies about plans for a variety of cost-cutting moves.  3% reported that they had reduced their defined-contribution match as of last month, while 7% reported plans to do so this year. Emily Brandon, at the Planning to Retire Blog, has a list of 31 companies that have announced 401(k) match cuts or plan modifications recently.

When money’s tight, it’s not unusual for employers to reduce costs by cutting their 401(k)/403(b) matching contributionsDuring the 2001 recession, a number of companies took an axe to their 401(k) matches.  The moves are usually temporary, and within a year or two the employer match is reinstated.  But these days, reductions in future employer contributions come on top of steep declines in existing retirement assets, adding insult to injury.  People who already felt that their retirement horizons were receding are seeing them slip even farther away.

For most people, it makes sense to contribute at least enough money into your 401(k) as is needed to maximize the employer’s matching contribution.  But what if your employer used to provide matching contributions for your 401(k) account but no longer does?  I’ve seen a variety of opinions expressed in articles on this point, including some that say you should actually increase your contributions if your employer’s contributions have been cut.  Well, I’d say it depends.

Pay off high-interest credit card debt
Suppose, for example, you have credit card debt that’s costing you obscene amounts of interest every month. When you were getting a 401(k) match, it might have made sense to contribute to your retirement plan because getting a match is like getting a guaranteed return that could be as high as 100%.  If the match has gone away, think seriously about increasing your credit card payments in order to extinguish high-interest debt.  Once that’s done, you can go back to saving for retirement.

Build up your emergency fund
Let’s say you’re not stuck with credit card debt and are paying your credit cards off every month – but you have no money stashed away as an emergency fund. If you keep shoveling money into your 401(k) and you get laid off and need money, you’re not going to be able take the cash back out without owing a tax penalty.  Shifting those contributions to build up an emergency fund could be an excellent idea, especially in the current economy.

One strength of the 401(k) is that the money being saved comes right out of your check, but you can probably set up deposits directly from your paycheck to any account you choose, with the same “forced savings” effect.

It’s all about tax rates
Now, suppose that you pay your credit cards off every month and you have an adequate emergency fund all set up.

Even in this situation, the decision to keep funding your 401(k) is not a slam-dunk.

Remember that a central argument in favor of 401(k)’s and deductible IRA retirement savings plans is the assumption that you’ll be in a lower marginal tax bracket in retirement.  If that’s true, getting a tax reduction now in order to pay lower taxes in the future is a smart idea.  But if your tax rate is higher in retirement, things change.

How could your taxes be higher in retirement?  Well, income tax rates right now are close to historic lows.  The government is taking on debt at an accelerated pace to try to bolster the economy.  Is it inconceivable that rates will have to go up long-term in order to pay the bills?  I don’t think so.  I’m aware of a paper that argues that having higher marginal rates in retirement is very improbable, but I don’t buy the argument, and when I get time I’ll try to prepare a piece showing why.  Even if income tax rates don’t go up, the favorable tax treatment given to social security benefits could be changed, effectively increasing retirement tax rates.

It seems to me that a person without a 401(k) match should consider other options, including shifting funds to a Roth IRA (if eligible to do so) or splitting retirement saving between the non-matched 401(k) and a Roth IRA.  Either of these approaches will require some number-crunching; if you put less money into your 401(k), your current tax bill will go up.  That may not be a bad thing if it means you avoid future taxes at higher marginal rates.

The argument that people whose employers have cut their match should increase their 401(k) contributions seems unrealistic to me.  Most of the clients I’ve worked with already contribute as much as they can afford to their retirement plans – increasing their contributions is a nice idea, but where will the money come from?  In practice, there are very few people who manage to max out their 401(k) contributions; fewer than 10% of those saving into 401(k) plans are maxing out, and that probably reflects the fact that few people can afford to do it.

Something else to consider is that when you save all your money into a 401(k) or other defined contribution plan, the money you eventually take out is taxed at ordinary income tax rates.  Suppose a good chunk of your retirement savings money is invested in stock mutual funds.  If you’d held those funds in a taxable account long-term and sold them, you’d pay capital gains tax rates on them when you sold them.  If capital gains rates remain lower than ordinary income rates, you could (in principle) wind up paying higher tax rates on money taken from your retirement account than you would have paid if you’d made the investment in a taxable account!

My thinking is that savers should take advantage of all the different tax treatments that are applied to different types of accounts.  If you’re in a situation where your employer has suspended the 401(k) match, it might make sense for you to make strategic contributions to long-term savings in Roth or even taxable accounts as a way of obtaining “tax diversification.”

Moreover, you should think about the tax implications of different types of investments and try to hold each investment in the type of account that provides maximum tax benefits.  This is sometimes called “asset location.” I’ll try to write more about this in the near future.

The bottom line is this: if your employer’s 401(k) match has changed, examine your retirement savings strategy in light of your all your finances.  Staying the course may be the right response, but you need to examine all the facts of your situation instead of relying on one-size-fits-all solutions.

About the author

Thomas Fisher, CFP®
Thomas Fisher, CFP®

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