Until the 1980s, most of America used pensions to plan for retirement. These defined-benefit plans offered by employers saved a fund on behalf of their workers and calculated each employee’s retirement benefits individually. This put all the responsibility and associated risks on the pension fund and employer. In order to plan properly, they had to make estimates, including life span and projected earnings, for each employee and needed to have the enough savings waiting for every qualified worker. But once Section 401(k) in the Internal Revenue Code came around, the tax-advantaged 401(k) retirement savings account was born. Consider working with a financial advisor as you seek to find the most optimal ways to build your retirement savings.
What Is a 401(k)?
A 401(k) plan is a popular retirement savings vehicle offered to millions of Americans by their employers. When an employee signs up for a 401(k) through their workplace, they agree to put some of their paycheck into the account. There, the money goes to work in investments like bonds, mutual funds and other assets. The capital gains earned from these assets grow tax-deferred, meaning the account holder won’t pay taxes on that money until they withdraw it, usually in retirement.
According to the Investment Company Institute (ICI), 401(k)s represent almost one-fifth of the total U.S. retirement market. The ICI’s study also shows 401(k)s hold an estimated $7.3 trillion in assets, as of June 30, 2021. In comparison, 401(k)s only made up 17% of the U.S. retirement market 10 years ago, at $3.1 trillion.
The 401(k) plan is subject to an annual contribution limit, though. This was instituted because the IRS wants to avoid workers putting an inordinately large portion of their income into a tax-advantaged account like a 401(k). For 2022, the annual 401(k) contribution limit is $20,500.
What Are the Advantages of a 401(k)?
The 401(k) plan is popular for a reason. It comes with several benefits, including tax advantages, that encourage workers to include it in their retirement plan. By signing up for one, you can profit from features like the ones below.
Contributions to your 401(k) come directly out of your paycheck before taxes. As a result, that money does not count towards your taxable income, potentially putting you in a lower tax bracket. So, you may face a smaller tax bill than you would have otherwise.
Additionally, your savings grow on a tax-deferred basis. As long as the money remains in the 401(k) account, it does not face taxes. That includes any earnings you make, such as capital gains. You only pay taxes on these and your contributions when you make withdrawals. This may be useful if you are in a lower tax bracket once you hit retirement.
Some employers offer their workforce a matching contribution program. Within this arrangement, they match your 401(k) contributions up to a certain cap. A common program for many companies is a 50% match up to the first 6% you contribute to the account.
So let’s say you make an annual salary of $50,000. You contribute 6% of your earnings to your 401(k) retirement plan – $3,000. Your employer then contributes an additional 50% of that amount, meaning you earn another $1,500 on top.
Other employers offer a dollar-for-dollar match, meaning they contribute the same amount as you up to a cap. Thus, they double the yearly contributions to your 401(k).
401(k) plans take a lot of the savings work out of your hands. For example, you don’t have to manually organize where your money goes each paycheck. Your company can set up automatic payroll deductions or automatic contributions for their employees.
This also helps new workers avoid procrastination when they start working. An auto-enrollment feature helps new hires start saving as soon as possible.
In most cases, you’ll have to pay a 10% penalty fee when you withdraw too early from a 401(k). If you take out money before you turn 59.5, you’ll face this fee on top of income taxes. The only exception to this is the rule of 55, which allows workers who are fired, laid off or quit during or after the year they turn 55 to withdraw from their current company’s 401(k) penalty-free.
However, some employers give participants the chance to borrow funds from their 401(k). More specifically, certain plan sponsors allow participants to take a loan from their retirement plan. The rules and procedures vary between each plan, though. In most cases, the loans have a cap amount that you must pay back over time using payroll deductions. But the money does not face taxation as long as the loan meets specific rules and you follow your repayment schedule on time.
Alternatively, you can make a hardship withdrawal. You can use your 401(k) money to cover qualified expenses such as medical care, funeral costs, or college tuition. You need to demonstrate an “immediate and heavy financial need,” according to the IRS, to qualify for a hardship withdrawal.
All employers have a fiduciary responsibility to their employees through their 401(k). As a result, they must act in the best interest of the employee. This is thanks to the Employee Retirement Income Security Act, otherwise known as ERISA. So, your plan administrator can’t shape your 401(k) toward risky and expensive investments. Instead, they need to shape the plan around secure investments with reasonable fees. In addition, they must disclose information such as historical performance data and administrative costs. That way, employees can make informed decisions.
Also, ERISA tacks on another benefit for participating workers. Because of it, your assets are safe from creditors. However, this does not protect your funds from specific government measures, such as criminal fines or income tax.
What Are the Disadvantages of a 401(k)?
While a 401(k) comes with potential benefits, they also feature some drawbacks. Understanding the potential disadvantages of a 401(k) allows you to better plan for your future. So, keep these downsides in mind during your retirement planning.
Limited Investment Opportunities
A 401(k) is a long-term savings and investing plan. So when you put money into it, you have the option of purchasing various investments. However, plan sponsors are responsible for the selection available to participants. Many create a list of mutual funds, with half of them as target-date funds.
Target-date funds are a collection of investments that grow progressively more conservative as you near retirement. These funds are usually titled and, therefore, coincide with the expected retirement year of the individual.
Because of potential limitations, it’s best to compare all your options in a 401(k) plan. If you can’t find a selection that fits your financial needs, you may need to consider a separate investment account.
A 401(k) plan is not free of charge. It typically comes with several expenses, including management and record-keeping fees. While any plan should disclose fees on an annual basis, it can still catch participants off guard. As a result, you may be paying high fees without understanding why.
If you have concerns about the cost of your 401(k), it’s always good to contact your workplace’s HR department. Or, you can reach out to the plan sponsor. Either can help you read through the plan’s fine print. Additionally, they can help you break down the employer’s matching program. In some cases, this may help compensate for the loss caused by the fees.
“Hard to Access” Funds
While you put your own money into a 401(k) account, you can’t just dip into it whenever you want. There are rules in place that can result in consequences if you do.
In most scenarios, withdrawing from a 401(k) plan before you hit age 59.5 makes you subject to a hefty IRS penalty. If you fail to follow the withdrawal rules, you must pay a 10% fee on top of the postponed income tax on the money. There are very few scenarios that allow you to access your money before this point, again, aside from the rule of 55 mentioned above.
Minimal or Nonexistent Employer Match
In some cases, employers match up to specific amount of your plan contributions. The match limit amount might be a certain percentage of your salary or your own contribution. Or, your employer may express the cap as a dollar amount. For instance, an employer may offer to match up to 100% of your contributions up to “x” amount. But the availability of a 401(k) matching program depends solely on your employer, as not every workplace offers one. Even if they do, the match may not be for much money.
While not always a red flag, you may also want to pay attention to when your employer matches your contributions. Some workplaces have minimum service requirements, meaning the employer only matches contributions after you work a certain amount of time.
What Are the Alternatives to a 401(k)?
There are a few reasons why a 401(k) might not be right for you. Maybe your employer doesn’t offer a contribution matching program. Or perhaps you don’t want to accept the high fees. In that case, it may be worthwhile to consider other retirement plan options. Below are a handful of possible alternatives that might fit your plans better. Note that you can have both a 401(k) and an IRA at once, though they each have their own contribution guidelines.
The traditional IRA is a popular retirement savings option, regardless of whether you have a 401(k). It allows you to put your money away and grow it tax-deferred. So, you only pay taxes when you withdraw funds during retirement. In addition, you can use your contributions to lower your yearly taxes. You just deduct the amount you contribute from your taxable income.
Like a 401(k), you pay a penalty for early withdrawals and must take out required minimum distributions (RMDs) starting by age 72.
The contribution limits are lower with an IRA, though. For 2022, you can only deposit up to $6,000 annually, at least until you turn 50. After that age, you can contribute an extra $1,000 per year, bringing the “catch-up” contribution limit to $7,000.
A Roth IRA is a similar store for cash before retirement, but it has unique features. In particular, you contribute after-tax dollars with a Roth IRA. So, you can’t reduce your taxable income before you put the fund away. But, because of this, your money grows tax-free, and you avoid taxation on withdrawals made during retirement.
Roth IRAs follow the same rules on contribution limits as traditional IRAs. However, there are income limits for who can contribute to a Roth IRA account. For 2022, single filers and heads of household with a modified adjusted gross income (MAGI) less than $129,000 (or $204,000 for married and joint filers) can contribute the full amount. Those who make more face decreased contribution limits, with contributions being fully phased out at $144,000 and $214,000, respectively.
In some cases, your employment status might push you toward other retirement plan options. A SEP IRA, or simplified employee pension, are open to self-employed individuals or small business owners.
SEP IRAs work similarly to traditional IRAs: they share a range of investment choices and tax advantages. However, SEP IRAs have the additional benefit of higher contribution limits. For 2022, your SEP IRA contribution cannot be more than 25% of your yearly compensation, or $61,000. However, your limit depends on whichever amount is less.
Taxable Brokerage Account
Maybe none of the available retirement savings options fit your situation. Or perhaps you already maxed out your contribution limits. In that case, it may be time to consider a taxable brokerage account.
While they offer no tax advantages, you don’t face withdrawal restrictions. You can use the funds whenever you please and it won’t affect your tax bill. Plus, there are many brokerage accounts that come with minimal fees and you have complete customization over your investment choices.
Is Investing in a 401(k) Right for You?
Overall, if you’re wondering whether a 401(k) plan is worth it – it depends. There are two major benefits that appeal to employees using a 401(k) plan: the tax savings and employee matching programs.
By contributing to a 401(k) you reduce your yearly income, thus lowering your tax burden. Plus, you can take advantage of the deferred taxation and the additional savings available through your employer. But this may not be enough for you.
Other investment options may come with lower fees or greater flexibility. That can be valuable to certain investors. Plus, you may not want to have restrictions on your own money. Work through your investment goals before enrolling in a 401(k) program. If you need to, talk to a financial advisor.
Bottom Line: Is a 401(k) Worth It?
A 401(k) is a popular way for many Americans to start saving for retirement. They are easy to set up through the workplace and come with various benefits. But they may not be available to you or the right choice. In that case, it’s important to consider your options. Look for a retirement savings plan that fits your present and future financial goals. That means taking into account contribution limits, potential tax consequences and fees.
Tips on Saving for Retirement
Planning for retirement can be quite an undertaking. Many of us aren’t equipped to handle it alone. The good news is that you don’t have to, as a financial advisor can guide you through the process. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Having a retirement age in mind can help you plan out your savings. But that might also be extra financial pressure. You want to make sure you’re saving at the right rate to support yourself in the future. That might require taking advantage of your employer’s 401(k) matching program. It’s essentially money already owed to you that can make a difference in your long-term savings.
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