We rave about the benefits of 401(k)s, because for most folks they are the first and best option to begin building wealth. However, they also have their drawbacks…
These days it seems like everyone has a 401(k) plan. Have you considered signing up for one but aren’t sure how they work? In this post we’ll go through the pros and cons of 401(k) plans, and some of the common gotchas to watch out for.
What is a 401(k)?
Before we dive into the positives and negatives of a 401(k), let’s first define what it is.
A 401(k) is a retirement savings and investing plan provided by for-profit companies. If you work for a nonprofit company (or a government org), the equivalent plan is called a 403(b). If you serve in the military, the TSP is your equivalent retirement plan. Employees who contribute to a 401(k) plan have funds deducted automatically from their paychecks. These funds are then invested into funds chosen by the employee (from a list of available options).
Contributions to these retirement plans are pre-tax. Meaning they can lower an employees taxable income for the given year. In 2023, the annual contribution max was set at $22,500 ($30,000 for individuals 50 and older).
Employees can contribute to an individual account by enrolling in automatic payroll deductions. The tax reduction comes either when you contribute money or when you withdraw it in retirement, depending on the type of plan you have.
If you were playing on your phone during your job’s HR orientation, you might have missed the best part – often there’s free money involved!…
Pros of 401(k)s:
There are numerous benefits to opening a 401(k) account. Here are some of the best features:
1. Company Match
It’s like free money! Many companies who provide a retirement plan also match employee contributions. These are additional dollars that increase the value of your account.
For instance, your company might match 100% of what you contribute to your retirement plan up to 6% of your income. If you earn $50,000 per year and contribute at least 6% or $3,000, your employer will also contribute $3,000 on your behalf. You’d have $6,000 in total contributions and receive a 100% return on your $3,000 investment, which is tremendous!
Related: The 7 money gears
2. Lower Taxable Income
Workers who participate in tax-deferred 401(k) plans set aside a portion of their wages before federal and state income taxes are withheld. These plans will save you money today (but you’ll pay taxes on the back end). Money deducted from your take-home pay and invested in a 401(k) reduces your taxable income, allowing you to pay less income tax in the current tax year.
For instance, let’s say your salary is $40,000 and your tax bracket is 25%. When you contribute 6% of your salary into a tax-deferred 401(k)— $2,400—your taxable income is reduced to $37,600.
3. Automated Savings via Paycheck Deduction
Automating savings through a payroll deduction forces folks to pay themselves first. And making it automatic is one of the most effective ways to save money. When you automate your savings, you increase your chances of growing your nest egg.
Have you recently received a pay raise? If so, consider increasing your bi-weekly contribution. If you have a percentage of your paycheck directly deposited into your 401(k) account, this will happen automatically.
Automatic escalation is another approach to automatically enhance your savings, based on the features available in your retirement savings plan. Basically this feature lets you automatically increase the percentage you contribute to retirement each year until you reach a specific percentage goal. It’s an awesome way to fight lifestyle creep, allowing you to save more as your salary increases over time.
4. Roth Options
Roth 401(k)s are becoming more popular perhaps due to the way they are taxed. Contributions to a Roth 401(k) are not tax deductible; but earnings and withdrawals from a Roth are not taxable at retirement if the rules for taking money out are followed. Although it may appear burdensome when you are contributing, you will relish having all of your payouts tax-free when you retire.
The max contribution is the same for either a Roth or Traditional 401(k). However, be aware that you can’t “max out” both – the annual limit is split across both types of accounts. A Roth version may work best for folks who are excellent savers.
Related: The beauty of a Roth IRA
5. Solo 401(k)
This is one of the best financial tools for freelance and gig workers. Solo 401(k)s let you administer your own plan, stuffing even more into pre-tax savings.
If you are self-employed and do not have any employees, you can have a solo 401(k). To speed your account growth, you can contribute a percentage of your paycheck or self-employment income and choose from a variety of savings and investing alternatives such as CDs, stock funds, bond funds, and money market funds.
6. Protected from Creditors
The Employee Retirement Income Security Act of 1974 (ERISA) protects qualified workplace retirement programs like your 401(k).
Let’s assume you have money in a qualifying account but lose your job and are unable to pay your auto loan. If the vehicle lender obtains a judgment against you, they may seek repayment from you in a variety of ways, but not by raiding your 401(k) or 403(b).
However, there are some exceptions, such as when you owe federal tax debts, criminal fines, or an ex-spouse under a Qualified Domestic Relations Order.
Cons of 401(k) Plans:
Despite all the wonderful benefits to having a 401(k), there are also some drawbacks that might have you hitting the pause button.
1. Vesting Periods
If your company contributes to your 401(k), the funds may not be immediately available to you. This is called a vesting period which can act like golden handcuffs.
Companies frequently have vesting schedules, which indicate how long you must work at a specific job before you own the funds that the company has contributed. If you quit before the funds have been vested, you will not get the money that is still owed by your employer. Once funds are completely vested, they remain in your account even if you change companies.
2. Limited Investment Options
Your 401(k) or 403(b) may have fewer investment options than other types of retirement plans. IRAs and taxable brokerages have a lot more flexibility. There are no unusual options, only fundamental asset types such as stocks, bonds, and cash funds.
On the flip side, having a limited investment menu streamlines your investment choices and minimizes complexity.
3. Sneaky Fees
As with most retirement/investment accounts, there are a ton of fees involved. Some of them are justified (there’s a lot of administrative responsibilities required by employer-sponsored plans), but also many are not!
Many 401(k) participants pay an average charge of 2.2% of their total assets. Ouch! The majority of account holders however pay a fee ranging from 0.2% to 5%. These percentages may appear insignificant, yet they can have a significant long-term impact.
Unfortunately, as a plan participant, you have little control over what fees you pay. When feasible, choose low-cost index funds or exchange-traded funds (ETFs) to keep your workplace retirement plan fees as low as possible.
Another situation that can create unwanted fees is early withdrawals. With a 401(k), you are penalized 10% for early withdrawals if you make them before the age of 59½. Additionally, you can’t tap into your 401(k) or 403(b) unless you have a qualifying hardship.
Related: Most common fees and how to avoid them
4. Manual Processes are Painful
If you’re looking for high-tech features in your 401(k), prepare for disappointment. There’s a ton of physical paperwork and arduous forms to fill out to amend 401(k)s. Not to mention the rollover process is confusing with few user-friendly options for moving money around.
Although some plans now provide app access, many 401(k) plans only allow you to view your account through an employer website. In most circumstances, a mobile app will not allow you to make or adjust contributions or perform other financial operations.
5. Many Accounts Go Forgotten
In 2023, there were an estimated 29.2 million “left-behind” or “forgotten” 401(k) accounts holding approximately $1.65 trillion in assets! How is this possible?! Well, it’s most likely a combination of people either forgetting, or being too lazy to figure out how to roll over their previous work-based account into their current one.
“Forgetting” about your investments isn’t always a terrible thing because the longer you leave it alone, the more it compounds and grows. The main concern, though, is that 401(k) plans are infamous for hidden fees and limited investment options, which can cost you hundreds of thousands of dollars before retirement.
What can you do? Be sure to track all your accounts and investments, when you leave a job, roll over your 401(k) either into your new employer’s plan or an IRA account, and always watch your fees.
Another option – Capitalize is a free tool that helps people roll over their 401(k). They can help you move yours to a low-cost provider. Check out our full Capitalize review here.
The Bottom Line:
All in all, 401(k)s are great plans while you are working at an employer. They reduce your taxable income, automate saving, and potentially help to snag you a sweet employer match!
If you work for a company that provides a 401(k), or its nonprofit equivalent 403(b), it’s a fantastic benefit that you should likely take advantage of.
However, when you leave your employer, 401(k)s become expensive and potentially harmful to your retirement savings. They can be riddled with fees, limited fund options, and you’re usually better off rolling over those funds to another retirement vehicle (like an IRA!).
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