The 401(k) retirement plan has been a savings option for Americans since 1978. It has grown to become one of the most popular choices for saving for retirement, with millions of people benefiting from the advantages that this structure offers. Employers are even using it as a way to distribute stock to employees or to make contribution matches.
It is an option that is also available to the self-employed, endowing a part of your paycheck to it before cutting yourself a check. A variety of investment options are available in this scenario, including stocks, bonds, and money market funds.
Some variations of the 401(k) retirement plan are starting to appear, including safe harbor and SIMPLE options. All of them have the same advantages and disadvantages to consider since the money comes out on a pre-tax basis. That means your annual taxable income is lower, and it will stay that way since your disbursements will likely come when your income brackets are at a lower level.
If you need to save for your retirement, then these are the various advantages and disadvantages of a 401(k) retirement plan to consider.
List of the Advantages of Having a 401(k) Plan
1. A 401(k) provides a large contribution limit that you can use to save money.
You can save a lot of money in a 401(k) retirement plan when compared to an IRA. The 2019 tax year allows you to put $19,000 into this tax-advantaged plan. If you are 50 years of age, then you can contribute another $6,000 to that figure. The 2020 tax year is going to increase those limits by $500 and $1,000 respectively.
Employers have the option to contribute to your 401(k) retirement plan if they prefer as a way to offer you a higher salary without tax implications. The 2019 tax year provides a $56,000 limit on all combined contributions, and it will go up by another $1,000 for 2020. If you’re over the age of 50, then the combined limit goes to $57,000 or $63,500 depending on your age.
2. You can still contribute to a 401(k) plan at retirement age.
Some retirement accounts don’t let you contribute to them once you reach the age of 70.5. This rule applies even if you’re still working. That means any money that you contributed on a pre-tax basis gets taxed at your current rate, and that figure is likely going to be higher than when you decide to eventually retire.
You don’t have this issue with a 401(k) retirement plan. You can continue to contribute as long as you continue working. You don’t even need to take mandatory distributions from the plan if you own less than 5% of your employer.
3. A 401(k) plan offers shelter from creditors.
If you find yourself in a challenging financial situation, then it can be helpful to have your money in a 401(k) retirement plan. It provides an excellent shelter for your funds from creditors because the rules that govern them are under the Employee Retirement Income Security Act. These accounts are usually protected against judgment creditors.
You’ll also receive some protection against federal tax liens if you have unpaid back taxes. Since the 401(k) retirement plan technically belongs to your employer instead of you, it is difficult to collect the funds from that account. Some plan administrators have the right to refuse to complete with any liens.
4. Some people may have the option to contribute to a Roth 401(k).
If you have concerns about what your tax rate will be when you retire, then a Roth 401(k) retirement plan could be an option to consider. You must contribute post-tax money into this account, but then you get to grow your wealth tax-free. When you take a disbursement from a Roth account, the after-tax nature of the money means that the withdrawal is 100% tax-free if you meet the conditions of that action.
If you have concerns that your dividends, RMDs, and Social Security payments could cause your income to rise in retirement, then this option can make it easier to manage your money.
5. You have the option to make an emergency withdrawal.
The 401(k) retirement plan allows you to borrow the money that you have in the plan if you have a qualifying financial crisis or personal emergency. The terms of your plan will dictate what is allowable in this circumstance. You typically need to pay the money back or face the penalties that get associated with an early disbursement. Most plans allow you to take a loan out against these funds, but it could also entail a direct withdrawal.
6. High levels of matching are available with 401(k) plans.
Employers can contribute up to 6% of your salary to a 401(k) plan unless you are a high-wealth earner. Then you have a maximum cap to consider with this retirement option. That means you are essentially receiving free money from your employer when you choose this option as a benefit. You might need to put a specific percentage of your income into the plan to gain the money, and a vesting period might apply.
You don’t need to accept this benefit, but it also means you’re leaving money on the table if you do. When you leave your job, then the account can roll over into another one or a different tax-advantaged vehicle to help your savings continue growing.
7. Tax deferments happen in the structure of a 401(k) plan.
You won’t need to pay any taxes on the money that grows in your 401(k) retirement plan until it is time to take a disbursement. That means you can avoid issues with interest or capital gains until you’re ready to use it for income. When you have a Roth 401(k), then you typically don’t even need to worry about this issue at all. Investing in high-dividend stocks that you can then reinvest into more is an easy way to watch your money multiply over time.
Since you also get to deduct the amount placed into the 401(k) retirement plan from your net income the year it occurs, you can gain a needed benefit on your taxes for the year.
8. If you take a 401(k) loan, then the interest you pay goes into your account.
The 401(k) retirement plan allows you to take a loan out against the amount you have saved if a financial emergency arises. You must repay this amount to avoid the early withdrawal penalty, and the funds might count as taxable income for that tax year. The advantage here is that the interest you pay on the loan goes into your account instead of to a bank or credit union. That means you can get access to the money you need while helping your account grow when you make the monthly payments on time.
9. You take the money with you when you leave.
Although you won’t get to take any matching funds that haven’t vested if you quit your job or get fired, the remainder of what you’ve saved can roll over into another 401(k) retirement plan. That means you can take the money with you whenever you leave. This benefit allows you to have some measure of management over the funds so that you can save for your later years in whatever way suits you the best.
It can be easy to think that you’re done once you set up a plan, but asset allocation and balancing is a task that should happen each year. Most 401(k) retirement plans allow you to take those necessary steps.
List of the Disadvantages of Having a 401(k) Plan
1. You must self-administer your 401(k) plan to maximize your options.
Most of the 401(k) retirement plans that you receive as an employer-related benefit offer limited flexibility. You won’t have the same number of investment options as you would if you self-administered the plan. Most give you risk classifications without any control over what gets bought and sold, and then you must pay an annual fee out of that savings amount for those activities. Even if your account loses money during the year, those costs are going to come out of your retirement savings.
It is imperative for you to have a good understanding as to where your funds are going when you save in a 401(k) retirement plan. Don’t settle for a simple answer from HR or a brochure from the administrator. Request specific details.
2. It excludes IRA deductibles.
If you contribute to a 401(k) retirement plan, then that activity can reduce or even eliminate the income tax deductions that get allotted for an IRA. That means high-wealth earners may not experience any benefits from having a traditional IRA while not qualifying for a Roth IRA. If you make less than $100,000 per year than this disadvantage may not apply. Even if it does, your income should qualify you for Roth benefits that let you take advantage of post-tax investments in these advantaged plans.
3. Unless you have a Roth 401(k), you’re going to pay taxes on your withdrawals.
When you start to take money out of your 401(k) retirement plan, then you will receive a tax bill on that figure because the IRS sees it as additional income. If you are 59.5 years of age and still working while taking money out, then the income levels could put you into the next tax bracket. That means it is possible to pay more in taxes each year with this retirement plan than if you’d simply taken the money out when it was first earned.
The income taxation also applies when you take an early withdrawal from your 401(k) retirement plan. You can pay up to 20% on the amount that you take, along with a 10% penalty if you’re under the age of 59.5.
4. You might need to navigate a waiting period to start a 401(k) plan.
If you are a self-employed individual, then a 401(k) plan is something that you can get started right away. Some employers require workers to go through a waiting period before they can initiate this retirement option, with the two most common times being six months and 12 months. That means you could wait for up to a year before you can start saving for your retirement with this workplace benefit. IRAs can supplement these savings for some workers, but it could put you at a disadvantage if you’re an older worker who wants to save as much as possible.
5. Your contributions follow a specific schedule.
Trying to time the stock markets is a recipe for disaster. If you steadily buy small amounts during the highs, lows, and plateaus that happen, then you’ll pay less for your investments than if you always try to buy at the lows. That doesn’t mean there aren’t times when you’d rather hold off on a purchase or increase the amount during a sale. You won’t receive these options when you’re saving with a 401(k) retirement plan.
Purchases follow a regular schedule with these plans. Any changes that you want to make take time to complete. Most administrators limit the number of adjustments that you can make during the year – or over the lifetime of your account.
6. The fees on your 401(k) plan could be very high.
Employer-sponsored retirement plans have heavy regulations governing them to prevent financial abuses. Your company can’t put vesting requirements on withheld wages, but this advantage comes with the disadvantage of higher fees. These costs are usually put into the mutual fund expenses, although some administrators with itemize the costs as separate charges.
In a perfect world, your employer would perform its due diligence when choosing an administrator. That doesn’t always happen. When you work for a small company, then you’ll typically pay higher fees because you can’t take advantage of an economy of scale. Those who save in a large plan have fees that range from 0.37% to 1.27%. Some employers might pay these costs, but most will not.
7. You have fewer options available for touching your money.
Did you know that you can withdraw up to $10,000 from an IRA to make a first-time home purchase? You can also withdraw any amount from an IRA without penalty to cover higher-education expenses. If you try to make that happen with a 401(k) retirement plan, then you’re going to get hit with that 10% penalty during that tax year.
Even if you have medical bills that are piling up, the IRS doesn’t let you touch the money in a 401(k) retirement plan until your costs exceed 10% of your income. You can also access the money if you become unemployed after the age of 55.
8. Your 401(k) loan gets capped by the federal government.
If you need to take a loan from your 401(k) retirement plan, then there are specific caps in place that you must consider before taking the money. The government limits the maximum amount to either $50,000 or 50% of the vested amount. You must also repay the loan within 60 months to avoid encountering the tax penalty. It is up to each plan sponsor to determine if loans are allowable, along with what the application procedure and repayment requirements will be.
An IRA doesn’t allow for loans at all. You can take advantage of penalty-free hardship loans with both options, but you must still meet all of the strict requirements before the outcome can happen.
Do you need to contribute to a 401(k) retirement plan to have enough money saved for your later years in life? Not necessarily.
What you need to have is a savings plan that can help you to compound wealth as you save some money each month. The 401(k) retirement option makes it easy to accomplish that goal. That’s why almost $6 trillion in assets are currently held in these plans in the United States as of 2019.
You can deduct your contributions from your tax return in the year that you make them. It provides protection from creditors so that you have access to these funds, including a layer of defense against the IRS in some situations. When you withdrawal the money, then you get taxed at the prevailing rate at that time.
Although the 401(k) advantages and disadvantages can be costly in some situations, it is usually a beneficial way to plan for retirement. The employer match, high contribution limits, and shelter gives you a resource that’s usable at a time when you need the income the most.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.