Stop That 401(k)!

By Daniel Kadlec

For most of your life, building a nest egg by investing regularly in a 401(k) or Roth IRA or low-cost variable annuity is a no-brainer. You get decades of tax-free growth (returns on stocks have averaged about 11% annually the past few decades), and in the case of a 401(k), you also get an up-front tax deduction. Try getting that in a taxable stock mutual fund at Fidelity or Vanguard. Those of you who get a matching contribution from your employer can count additional blessings.

There's a hitch, of course. If you need to tap your tax-deferred savings early, you'll pay a penalty. And at some point, you must begin taking minimum amounts out or pay another penalty. Worse, with a tax-deferred account, you or your estate will eventually get socked with income tax on withdrawals at federal rates up to 39.6%--not the relatively friendly capital-gains rate of 20% that applies to other long-held investments. Still, tax-free growth far outweighs any of the negatives that come with it--for most of your life.

The equation starts to shift, though, as you near retirement age. In some cases, late in your career--say, five years from retirement--it makes sense to stop contributing to tax-deferred accounts and stash your money in a taxable low-cost stock-index fund instead. Why? Because the compounding effect of tax-free investing needs years to overcome the higher tax rate applied to such accounts at the time of withdrawal. And taxable accounts get the benefit of skipping capital-gains tax altogether when the account changes hands at death.

For most people, it almost always pays to continue contributing to a 401(k) until the day you retire. The up-front tax deduction, tax-free growth and employer match are that powerful. But a study by mutual-fund company T. Rowe Price suggests that in cases where the 401(k) plan has no employer match, the edge isn't all that great. A taxable stock-index fund might be your best savings vehicle late in your career.

Consider someone in the 28% tax bracket before and after retirement, saving $10,000 a year the five years before retiring. The money earns 10% annually. She withdraws equal amounts over 25 years and exhausts the account. Here's what her last five years' worth of contributions would net on an after-tax basis: $157,400 from a 401(k) with an average match; $121,000 from a 401(k) with no match; $102,300 from a taxable stock fund, and just $93,087 from a low-cost variable annuity. The 401(k) with a match is a clear winner. (If your employer doesn't match, maybe you should find one that does.) But the difference between the no-match 401(k) and the taxable fund is not all that great and may not be enough to compensate for drawbacks--losing easy access to the money and having to follow strict rules on withdrawals.

Where preretirees really mess up is in continuing to contribute to a tax-deferred variable annuity, often billed as the next best thing to a 401(k). Sam Beardsley, head of T. Rowe Price's tax department, says that in virtually every scenario he ran, investing in straight taxable funds late in your savings years produced more retirement income than a tax-deferred annuity. Other studies suggest that you need at least 20 years of accumulation before a tax-deferred annuity makes sense.

Hopefully, older really is wiser, because no-brainers are tough to find.

See time.com/personal for more on retirement. E-mail Dan at kadlec@time.com See him Tuesdays on CNNfn at 12:20 p.m. E.T.