Pros and Cons of 401(k)s
Weighing the pros and cons of 401(k) plans is a great way to determine whether or not to invest in one. Before enrolling take a look at some of these features of 401(k) plans.
Weighing the pros and cons of 401(k) plans is a smart strategy before enrolling in your employer-sponsored plan. A 401(k) is one of the most powerful tools when it comes to saving for retirement. However, without understanding the many features your 401(k) plan provides, it’s difficult to determine if it’s the right move for you.
The pros of 401(k)s include the ability to build a sizable retirement fund using tax-deferred contributions, get additional money from your employer, and can make saving for the future easy. The cons of 401(k)s are their limited investing options, a tendency for higher fees, and difficulty transferring accounts to other 401(k)s and IRAs.
How/If you save for retirement is an individual choice. Don't let a lack of understanding be the reason you don’t take advantage of this great wealth-building tool. We're going to help you by going over a few pros and cons of 401(k) accounts.
What is a 401(k)?
A 401(k) is a type of retirement plan typically provided by an employer. Those who are self-employed can contribute to a similar account, called a solo 401(k). These accounts allow you to save money and invest it in various mutual funds.
Since it is a retirement account, there are limitations to when you can withdraw your money. The standard timeline is age 59 1/2, however, there are certain scenarios where you can access your funds sooner - more on that later.
A 401(k) is a great way to automate and set aside money to grow until you decide to hang it up and retire. Nevertheless, 401(k) accounts may not be for everyone; at least relying solely on them for your entire retirement saving strategy may not be.
Pro - Your Employer May Match Your 401(k) Contributions
Many employer-sponsored 401(k) plans incentivize saving for retirement by matching what you put in up to a certain amount. Based on a Bureau of Labor Statistics Survey, over half of the employers who offer a 401(k) plan match a percentage of their employees’ contributions. On average, these employers match around 3%.
This can add up to thousands of dollars annually. Receiving a boost towards your retirement savings goes a long way when factoring in compounding growth. Adding an additional couple of hundred dollars to your 401(k) each month will help your account grow exponentially over time.
If your employer offers to match a portion of your 401(k) contributions, it's a good idea to take advantage. At the end of the day, free money is free money, even if you won't see it until later down the road.
Pro - Automated 401(k) Contributions
Many people don't contribute to retirement savings - or any savings for that matter. It's understandable, the temptation to spend your money is much greater than stashing it away. The problem is the longer you wait to save for retirement, the more you miss out on that compounding interest.
The old saying goes, "The best time to save for retirement is when you're young. The second best time is right now."
Your 401(k) account can help you save for retirement without even trying. You can request your HR department to automatically take out whatever percentage you choose from your paychecks automatically.
Your money will be deposited into your 401(k) account before you even get your hands on it. This is a great way to make sure your retirement account is funded without any lapses.
Pro - Higher Contribution Limits
The IRS sets limits on how much you can contribute to various retirement accounts. The IRS increases this limit every couple of years as the cost of living increases.
Currently, the contribution limits for 2020 and 2021 are $19,500, plus an additional $6,500 if you are 50 and older.
These limits are put in place to prevent high-earning individuals from benefiting unfairly from the tax benefits of 401(k) plans.
Chances are you won't run into these limits but it's worth noting to avoid any penalties and complications.
Pro - Tax Benefits
Contributions to your 401(k) are made using pre-tax earnings, including those made by your employer. Meaning that when taxes are taken out of your paycheck, the amount is calculated on what's left of your paycheck after you've sent money to your retirement account.
This is another boost to your retirement savings as more of your money can be allocated without Uncle Sam taking his share first.
More money saved in your account means more money that can grow over time. By contributing to retirement for decades, this marginal increase once again adds to the compounding interest you'll accrue.
Pro - It's Federally Protected
Your 401(k) isn't protected the same way your checking or savings accounts are protected. Although unlikely, you can still lose the money you've saved for retirement.
The Employee Retirement Income Security Act of 1974 (ERISA) was enacted to protect 401(k) plans.
That piece of legislation set many standards that employers and their plan administrators must meet to stay compliant. Some of the more notable features include:
- Disclosure of plan features and funding.
- A process to file claims and appeals to gain access to your fund's benefits.
- The right to file suit if the plan is mismanaged or fiduciary duties are violated.
You are also protected under ERISA from creditors. Should you default on a car loan or have an account go into collections, creditors cannot garnish your retirement funds. There are, however, stipulations like backed taxes and criminal penalties that may qualify for the surrender of your retirement money.
Pro - Can Take Out a 401(k) Loan in Times of Need
Although not usually advisable, you can gain access to your retirements in the form of a loan. Account-holders can take loans out against their 401(k) up to $50,000 or 50% of the balance, whichever is less.
There are stipulations that differ from traditional loans you would get, say at a bank. These typically include:
- A 5-year repayment term; the CARES Act temporarily extends this window to 6 years for loans outstanding after March 27, 2020, with payments due by the end of 2020. Check with further COVID legislations for more up-to-date guidelines.
- If you lose your job, you may have to repay the full balance by tax day the following year.
- You'll owe interest that is set by the account administrator.
- If you default, you'll incur penalties as the loan will be deemed a withdrawal rather than a loan.
Before taking out a 401(k) loan, check with your plan's administrator on the terms to determine if it's the right option.
Pro - Can be a "Gateway" into Other Investment Options
For many, contributing to a 401(k) is their first venture into investing. This can serve as an educational tool to learn more about a broad array of investing products.
Once you start seeing your account grow from both contributions and portfolio performance, it's only natural to inquire about other avenues of building wealth for retirement.
Most 401(k) plans default into a target-date fund. These are funds that predict when you're going to retire, then reallocates your asset holdings to match the risk tolerance as you near your retirement date.
Conversely, you can choose to invest in any other fund provided in your plan you deem right for your goals and risk tolerance. By opting into your employer's 401(k) plan, you'll have access to resources to learn about the various options for saving for retirement.
Con - Limited Investment Options
As stated previously, most 401(k) plans default to a target-date fund that matches your age. However, most plans offer a menu of mutual funds, index funds, and bonds that you can choose to invest in instead.
The downside with most plans is that this menu is rather limited when compared to what's available on the open market.
This can reduce the growth of your savings if it were invested in a fund that isn't offered by your plan. Now, nothing is guaranteed when it comes to investing, still, having more options to invest in is always better.
Con - May Have Higher Fees
Along with being limited in the types of funds you can invest in, your options of low fee funds may be limited as well.
Many index funds and mutual funds provided on the market come with very minimal expense ratios. Expense ratios are fees you pay to invest in a particular fund. The Vanguard S&P 500 Index Fund (VOO), for instance, has a mere 0.03% fee.
Alternatively, many funds charge 1% and higher to invest in. While compound interest is a good thing, compounding fees are not. They can stunt your growth overtime; eating away at the amount you'll have come retirement.
There's more to choosing an investment than simply fees, but if all you have to choose from are high fee funds then it may be something to reconsider.
Con - Possible Waiting Periods
To avoid employees from gaming the system by using benefits then running for the hills, companies can implement a waiting period before you're eligible for their benefits package.
This can include your 401(k) participation and match.
Saving for retirement early and often is the name of the game when amassing a nest egg. And if you're further along in life, this waiting period can be detrimental.
There's nothing stopping you from putting money into another retirement account during this time, like an IRA. You won't enjoy the tax-free contributions and the employer match if they provide one.
Once you become eligible for your company's retirement plan, don't hesitate to sign up to make up for the lost time.
Con - Limited Advice and Guidance from 401(k) Plan Provider
Every 401(k) provider is different. Some may provide great resources for their plan participants, others may not.
Because companies are competing for your business, when shopping for investment accounts on your own, they pull out the red carpet. On the other hand, some providers know that when it comes to your 401(k), you're limited to what your employer offers.
They assume you'll simply keep your money in the target fund and all will be handled for you. But if you want to take a more active approach to your investing, you may be left with doing your own research. And when it comes to choosing the right investment options, it can get complicated.
Con - Difficult to Organize Past 401(k) Accounts
When you leave a company, you're entitled to take your 401(k) with you.
If you forget to sort out all of the details before your last day, it can be difficult to track down the right department to find your 401(k)’s.
It can be a cumbersome process as you'll need to file paperwork with your former plan provider and instruct them on where to send the funds. Many times, they will send you a check that will need to have particular information on it, then mail it to your new plan provider. Along the way, wires can get cross resulting in costly roadblocks.
Luckily, Beagle takes care of all of this for you. We take care of tracking down your old 401(k) accounts, facilitate all of the transfers, and can consolidate your 401(k)’s into one simple IRA account with Fidelity, the number one 401(k) in the US. Get started here.
Is a 401(k) Right for You?
That's up to you. For many, automation, employer match, and tax benefits are outstanding benefits. For others who like more control over their investment options may opt for an IRA.
Getting started is the most important thing to remember. The time your money isn't invested for retirement, the more time it's missing out on opportunities to grow and compound.
Hopefully, by breaking down the good with the bad, you can make the right decision for yourself.