||Ask the Dollar Diva
Cash out your 401(k) early? Good idea!
Dear Dollar Diva,
I contribute 3 percent of my income
to my company's 401(k) plan; the company matches the 3 percent,
and I'm 100 percent vested. I'm going to college to become a teacher,
and will have to quit my current job in two years to student teach
for a semester. I plan to live on my 401(k) money while I student
teach for five months, but have been told I will lose about 40 percent
of my money to taxes. Should I keep contributing to the plan, or
invest the money somewhere else?
As a rule, you shouldn't use a 401(k) plan as a short-term
savings vehicle, but rules are made to be broken, and your strategy
is sound; even though you'll have to pay income tax and that nasty
10-percent early withdrawal penalty.
- Your employer match is giving you a 100-percent
return the second you contribute. That more than compensates for
the 10 percent early withdrawal penalty.
- 401(k) contributions are tax-deferred, not tax-free.
You don't pay tax when you make the contribution; you pay it when
you take the distribution, even if it's not an early distribution
subject to the 10-percent penalty. The deferred tax accounts for
most of the 40 percent you've heard about. Let's pretend you're
in the 27 percent tax bracket: Because of the tax deferral, a
$100 contribution to your 401(k) plan only costs $73. It wouldn't
hurt to set aside the $27 tax savings, since you know Uncle Sam
will be looking for it in two years.
- You won't be drawing a salary while you're
student teaching, so the 401(k) distribution is not likely to
kick you into a higher tax bracket. If it does, the employer match
would compensate, so it shouldn't change your plan. The Diva writes
about the dangers of slapping a big chunk of income on your tax
return in "4
good reasons for not tapping your IRA."
When the employer contributes,
even if you don't
If you have one of those nice employers who contributes
even if you don't, you need to rethink your strategy:
- Contribute to the 401(k) plan if your current tax
rate is 27 percent, but you expect to be in the 15 percent bracket
the year you student teach. The tax savings will more than compensate
for the 10 percent penalty.
- Do not contribute to the 401(k) plan if you expect
your tax rate to be the same or higher when you take the distribution.
Save your money outside the plan.
Where to stash the cash
Whether you save in your 401(k) plan or outside it, your time
horizon is short; preservation of capital is your primary goal.
You cannot invest in anything that depends on the
market for its value; forget about stocks and most bonds. Your cash
needs to be stashed in money market mutual funds, certificates of
deposit or U.S. savings bonds.
The Diva writes about investing for safety,
liquidity and the best rate in "Where
to open an emergency fund account" and "Where
do I stash my emergency cash?"
-- Posted: Feb. 14, 2002