Taxes and Cancelling my 401(k)

A reader commented on my post about cancelling my 401(k) about making sure I had considered the tax implications of my choice:

[The Traveling Man sez] I am not sure if you considered this or not, but you might have some tax consequences by discontinuing your 401k contribution. You fund the 401k with pre-tax dollars, so if you are maxing out your 401k, then you are reducing your AGI significantly. You may still find that it is worth it in other ways, but the seemingly large 1.4% expense fee on the fund won't seem like too much if it causes your takes paid to go up by more than that!

First I want to clarify that my decision had nothing to do with the high expense ratio of my index fund...it was just another data point in favor of the decision I already made for other reasons. But he does make an excellent point that there are tax consequences and I didn't really write about that part of my decision, so here goes....

By cancelling my 401(k) with only December left the tax impact for 2005 is only based on roughly $1100. My federal and state income taxes in December were obviously higher and I increased my monthly takehome pay by about $800 (and close to $400 of that went to the "extra" taxes). I was able to estimate this impact by using a dinkytown calculator and it was accurate enough for my purposes.

Also, my adjusted gross income for 2005 will include that extra $1100-ish so to offset that, I paid my January mortgage in the last few days of December. Since my January interest was more than what was "added" to my AGI it was a fair trade for 2005 tax purposes.

Which brings us to 2006. My intention is not to abandon my 401(k) forever - I have simply postponed my contributions in an effort to fast track some other savings that I feel are higher priorities due to my own personal set of circumstances.

I have never before had any "emergency fund" or savings account of any significance. I am not convinced that my job is stable and though we made it through some serial unemployment recently I am now even more aware of what that cost us financially in the long run because we had to use our home equity and credit cards as our "safety net". It wasn't horrible, I just dont want that to ever happen again. A liquid fund of $10,000 represents a small taste of freedom for me and I just can tell in my gut that we should go for it.

If my paycut is not reversed in 2006, my salary will be even less than it was in 2005 since the paycut came mid year. Even so, I still plan on putting at *least* $10,000 in my 401(k) by the end of 2006 (assuming I still have one!) and $12k might not even be that much of a stretch if everything stays the same. But I honestly don't think I can meet my other savings goals and still *max* my 401(k) by contributing a full $15,000.

Unless I get a raise ;) or get a side business off the ground...or or or!

Either way I will have to calculate a new withholding amount once the numbers settle down.