This post is part of a series in our Ultimate 401(k) guide.
If you participate in an employer-sponsored retirement program, it’s most likely a 401(k) plan.
The old school pensions our grandparents had are about as common as a dinosaur walking down the street with a cup of coffee. Over the last several decades companies have put more and more of the burden for retirement savings on employees like you and me.
As pension plans go extinct and the future of Social Security remains uncertain, the 401(k) has become the primary source of retirement savings for most people. Only about half of American workers are able to participate in a 401(k) plan (not all companies offer one).
So if you do have access to a 401(k) plan (maybe you just started a new job at a company that offers one) you might be wondering “is a 401(k) worth it?”
To answer that question, let’s take a look at some of the 401(k) pros and cons you’ll want to consider:
When I think about the benefits of contributing to a 401(k), there are four things that jump out at me.
It Forces You To Save Money
How many times have you heard personal finance experts stress the importance of paying yourself first?
Heck, it’s one of the most fundamental rules of building wealth. By paying yourself first you’re making sure that your savings goals are being funded before you waste your money on that new video game or kitchen gadget.
Investing through your 401(k) plan makes saving money easy and painless. Once you sign up, the money comes out of your paycheck automatically. You don’t have to worry about making a separate deposit or transferring money on your bank’s website.
It just happens all on its own, so even the laziest among us can save for retirement.
You’ll Save Money On Taxes
One of the advantages of investing through a 401(k) is the ability to contribute a portion of your paycheck with pre-tax money.
For example, let’s say your gross monthly income is $5,000. If you contribute $500 per month into your 401(k) you will only pay taxes on $4,500 instead of $5,000.
That lowers your taxable income and reduces the amount of tax you’ll pay.
Plus, the dividends and capital gains earned on your 401(k) investments are tax-deferred. That means you won’t be taxed on them at all until you start withdrawing money from the plan at retirement.
Deferring taxes on those earnings will allow them to grow much, much faster and that’s great for your bottom line.
Your Boss Might Contribute Too
Many employers will actually make contributions to your plan too.
For example, a typical employer contribution might be 50 percent of the first 6 percent you contribute. If you earn $60,000 a year and contribute 6 percent of your salary ($3,600) the company will contribute 50 percent of that amount into your account.
That’s $1,800 in free money!
If your company has a really good year they might even make an additional contribution, such as a Discretionary Match or a Non-Elective Contribution (NEC).
You don’t need to worry much about those, but if you get one consider it a nice bonus.
Protection From Creditors
Hopefully this will never be an issue for you, but if you find yourself in debt and creditors are coming after you it’s good to know that your retirement savings are safe.
Generally, creditors are not allowed to go near your retirement savings, and your 401(k) is also protected during bankruptcy proceedings.
Of course, 401(k) plans aren’t all sunshine and lollipops. They have their disadvantages too:
Potentially Higher Taxes At Retirement
While being able to contribute pre-tax money into your 401(k) and letting it grow tax free is a definite advantage, there’s another side to the story.
When you start withdrawing money from your 401(k) it gets taxed as income at whatever tax bracket you happen to fall into. That will likely be much higher than the long-term capital gains tax you would owe if you had invested that money outside of a 401(k).
If you earn around $100,000, your income would be taxed at 24 percent. But long-term capital gains taxes top out at the far lower 15 percent for most people, and 20 percent for those with higher incomes.
Note – in most cases the advantage of having your earnings grow tax free will far outshine the slightly higher tax rate when you withdraw your money.
Lack Of Flexibility
Your 401(k) doesn’t work like a savings account at a bank. It’s designed to be used for retirement savings, so in general it’s very difficult to take money out early.
Most plans do provide ways for you to access your money when you really need it through loans or hardship withdrawals but those have disadvantages of their own.
When you put money into a retirement savings account you should expect to leave it there for years to come. A 401(k) is definitely not a good place for your emergency fund.
Limited Investment Options
When you invest in an individual retirement account (IRA) you can put your money into pretty much any kind of investment, such as stocks, bond, mutual funds, ETFs and REITs. The choices are endless.
But with a 401(k), you’re limited to the investment options available in your plan. Generally they will include a collection of mutual funds that invest in various sectors so you can build a diversified portfolio. One might invest heavily in large companies, another in small companies, another in foreign companies, and another in bonds.
The problem is that your collection of funds might not be the best. They could be under-performing, poorly managed, or expensive compared to their peers.
Another problem with 401(k) plans are the high fees that secretly eat away at your account balance.
A report issued by the Investment Company Institute found that an average working couple making a combined $30,000 and contributing five percent to their 401(k) would pay an obscene $154,794 in fees.
If that same couple earned $90,000, they’d pay a mind-boggling $277,000 in fees!
The worst part is that the fees are hidden and difficult to find. They’re built into the funds themselves in the form of an expense ratio and you probably have to do some digging to figure how much you’re being charged.
When you compare the investment options available to you in your 401(k) plan, pay close attention to the fees charged.
The lower the fees the better.
Look for index funds or passively managed target date funds which will usually have fees that are just a fraction of what the actively managed funds charge.
The Bottom Line
If nothing else, this list of 401(k) pros and cons should leave you a little more informed. Although 401(k) plans are from from perfect, they can still be a powerful financial tool that will help you save for retirement.