When NOT to Contribute to a Retirement Account

Not Contributing

It is true that most people should start saving early and often for retirement. Since corporate pensions have started to die off, workers are left with only one choice: contribute part of their salary to a retirement account. I am constantly telling people, especially younger folks, that a 401(k) with a match is the best investment vehicle around, even better than an IRA with me! And they don’t just hear it from me. How often does a senior employee lament to a younger one the fact that he or she didn’t start saving earlier? It happens constantly.

There is a great amount of anxiety among workers when it comes to funding their retirement. In one recent study I saw, only 36% of nonretired investors thought their retirement savings were on track. Investors have convinced themselves that they need millions and millions of dollars to retire. While that may be true or not depending on your goals, the perception influences people’s behavior. Afterall, perception is reality. My point is: people have been beaten over the head that contributing to a retirement account is never a bad idea. I believe that is wrong.

Let me preface my comments by stating that it is always a good idea to contribute to a retirement account with an employer match. The match is part of your salary, and you should always take advantage of it if you can. Next, if your employer plan has a ROTH component, I have no problem contributing to that. Where I start to oppose contributions to employer plans is when the worker is close to retirement, there is no match, and all the contributions are tax deferred.

It is important to remember that every situation is different and if you are currently in a very high tax bracket then obtaining a tax deduction today may be a good idea. But for most folks who will be in the same tax bracket in their working years as in retirement, the tax break is a temporary one. Eventually you will pay the tax. That’s why for some people contributing to a non-retirement account or a ROTH IRA is a better way to go.

Every penny you withdraw from a traditional IRA or 401(k) is taxed at your marginal tax rate, in other words, the highest rate possible considering your overall income. Having money in a non-retirement account gets you access to a more favorable tax rate known as capital gains. And of course, a ROTH IRA is tax free. For couples earning under $80,000 per year, the capital gains tax rate is actually 0%! For those over $80k the rate is 15%. And regardless of your income your contributions are never taxed and are considered a return of principal.

In summary, having money invested in a non-retirement account gives you flexibility from a tax planning perspective. If your income is high for some reason one year, it can really help lower your tax burden. It’s also helpful if you need to make a big purchase during retirement. If you want to spend $30,000 on a new car and you take the money from your traditional IRA, that’s $30k going on your tax return that year as income. Diversification is important not only within your investment portfolio but also when it comes to the tax treatment of said portfolio.