Pros & Cons of 401(k)s
Overall, 401(k) plans are an excellent wealth-building tool. The benefits of tax-deferred or tax-free investing cannot be overstated.
With that said, 401(k)s aren’t completely without their “inconveniences”.
Here are several pros and cons of 401(k)s to help you decide just how these retirement plans best fit in your financial strategy.
Cons:
1) Early Withdrawal Penalties
Topping our list of cons are early withdrawal penalties that significantly restrict one’s access to their 401(k).
If you withdraw money from your 401(k) before you reach age 59.5, you’ll owe a 10% early withdrawal penalty in addition to any tax obligations you have.
For example, someone in the 22% tax bracket would owe 22% in income taxes for an early withdrawal from a Traditional 401(k) account, plus another 10% early withdrawal penalty, for a total tax obligation of 32% of the withdrawal amount.
The government set up 401(k)s to serve as retirement plans and they want to discourage people from using their retirement savings for another purpose.
There is a strategy called the Rule of 55 that allows one to remove money from your 401(k) as early as age 55. You can read more about it in this post about early withdrawals.
2) Limited Investment Options
Depending on how well your 401(k) plan is designed, you may or may not have access to a broad panel of investments within the plan.
These days, most 401(k)s tend to offer a small variety of small, mid, and large-cap mutual funds, an international option or two, a few bond choices, and a longer list of target date retirement funds for their investors.
It’s not that one can’t build a suitable asset allocation with this panel of options but having 15 to 20 choices is a far cry from the thousands of investments available through an IRA where there are potentially no restrictions.
With that said, more and more 401(k) plans are offering access to a brokerage account within the plan itself. Usually, there are higher fees for trading in these accounts, but at least it’s an option.
3) Expensive Plan Administration
Speaking of fees, 401(k) plans are administered by a single custodian that your employer selects to establish the plan.
As a result, the plan participants are a bit of a captive audience.
In many cases, employers do a good job pushing for cost-effective investment options and reasonable plan fees.
However, there are many plans out there that are just flat-out expensive. Usually, this is correlated with the amount or value of assets that are held in the plan.
There are costs associated with administering a 401(k) plan. So, if the plan custodian has fewer participants from which to glean fees, it will inevitably cost more for those employees than for workers in much larger plans.
Another way 401(k) fees can be high is within the investment options themselves. Often, investments in a 401(k) will have a higher expense ratio than similar investments available outside the plan.
Again, plan participants are a captive audience, and the administrator must recover their costs somewhere. Investment fees are another option for that.
4) Required Minimum Distributions
Finally, tax-deferred or traditional 401(k) earnings and withdrawals will be subject to Required Minimum Distributions (RMDs) when the account owner turns 73 or 75 depending on when they were born.
The purpose of RMDs is to create a taxable event from which the government can collect its portion of the long-deferred revenue that is in your retirement account.
If you need regular income from your 401(k) in retirement, RMDs may not concern you very much.
However, if you save very well and enter retirement with a significant amount of assets and income, you could find that RMDs are a bit of an inconvenience because they force you to realize income that you don’t need.
Not only that but because RMD income is subject to income tax, RMDs force you to sacrifice a bit of control over your tax situation.
There are several strategies to limit the impact of RMDs. You could keep working, make Roth conversions, or even conduct some charitable giving after rolling your 401(k) into an IRA.
For more about these, follow the link or check out our video about reducing RMDs.
Pros:
1) Employer Matching Contributions
Unquestionably, employer contributions are the greatest benefit to a 401(k) plan. The money your employer puts in your 401(k) is completely free, which is pretty hard to beat.
On average, employers are willing to match up to a little over 4% of the average American’s income if we just put money into our accounts too.
Even if you’re enrolled in a 401(k) plan that has high fees or your employer contribution isn’t a full dollar-for-dollar match, any contribution they make is probably going to leave you better off mathematically than investing elsewhere without any match at all.
In fact, in our Next Dollar Roadmap, these employer contributions are so important that they rank at our second milestone after building an Uh-Oh Fund.
Matching dollars are valuable. Don’t pass them up!
2) Tax-deferred or Tax-Free Earnings
Another benefit that significantly boosts the wealth-building power of 401(k)s is the tax efficiency they provide.
Depending on which type of 401(k) you contribute to, Roth or Traditional, your contributions or withdrawals can be made tax-free.
In either case, the earnings are allowed to grow completely tax-free (though earnings on traditional contributions will be subject to income tax upon withdrawal).
For example, let’s assume you contribute $5,000 a year to a 401(k) for 40 years while you’re also in the 22% marginal tax bracket. If you received an average rate of return of 8% over the course of this period, your account would have $1,398,905 when you reach retirement.
If you subject this balance to a 22% income tax, you’ll have $1,091,146 remaining*.
However, if you made the same contributions to a taxable brokerage account, receiving the same 8% return, and subject to a 15% long-term capital gains tax, you’d only have $927,474 to show for the same invested amount.
That’s $163,672 just by using a 401(k) to invest instead of investing in an account that doesn’t receive any of the tax benefits.
(*Note the same amount would be true for a Roth account, you’d just be taxed on your contributions instead of withdrawals.)
3) Tax Optimization
A second tax benefit of 401(k) plans is the option they give investors to choose when they pay taxes; either before contributions are made to the account (Roth) or when withdrawals are made in retirement.
This effectively means you can pay taxes when you’re in the lowest or optimal bracket for limiting your tax liability.
If you are in a relatively high bracket when you make contributions compared to where you expect to be when you retire, you’ll probably want to make tax-deferred or Traditional contributions.
On the other hand, if you’re in a relatively low tax bracket now compared to when you retire, you’ll probably want to make contributions on an after-tax or Roth basis.
For example, when I first started contributing to a 401(k) I was in the 15% tax bracket. That would have been a great time to make Roth contributions because I don’t expect to be in a lower tax bracket when I retire.
Alas, my employer at the time did not allow us to make Roth 401(k) contributions, but thankfully, times have changed.
Generally, if your combined federal and state income tax rate is below 25%, you’ll be better off contributing on a Roth basis. If your combined federal income tax rate is over 30%, you should look to Traditional contributions.
If you’re in that 25%-30% range you get to choose or you could hedge your bets and contribute to both.
4) High Contribution Limits
Offering a spacious $23,000 of tax-advantaged investing space, 401(k)s are among the most generous retirement vehicles offered.
The max goes up to $30,500 if you are 50 or older.
For comparison, the widely popular Individual Retirement Account (IRA) only offers $7,000 of saving space and up to $8,000 if you’re 50 or older.
Not only does the 401(k) offer more investing room, this $23,000 limit doesn’t include any contributions made by your employer.
Together, employee and employer contributions are limited to $69,000 in 2024 and $76,500 if you’re 50 or older.
Another nice feature of many plans is the ability to fill up this $69,000 limit with after-tax contributions that you can then roll over into your Roth 401(k). Not all plans allow this, so be sure the check your summary plan description for details.
5) Portability
Last on our list is the portability that 401(k) accounts offer.
If you leave an employer, you have the option of leaving your 401(k) where it is, you could roll it into another 401(k) at a new employer, or you could roll it into an IRA.
This flexibility is a real bonus because it gives you the freedom to change jobs if you want without having to sacrifice your retirement savings.
If you are thinking about a job change, be sure to review the vesting schedule for your 401(k) plan. Some plans require you to work for 1 or more years before employer contributions to the plan fully vest. Any unvested funds would be forfeited if you changed jobs.
Wrap Up
Boasting over $7.5 Trillion in assets, 401(k) plans are the primary retirement investing vehicle for most working Americans.
I’m not sure if you were keeping score as we walked through these pros and cons, but if you did then you’d see that the pros clearly carry the day.
A 401(k) account is an excellent retirement boosting tool and you should take advantage of it if you have access to one.
