If your employer offers a 401(k) plan, contributing to it is an easy way to set aside funds for retirement.
These accounts are designed for long-term saving and include some key advantages. However, you’ll want to be aware of the potential downsides attached to a 401(k). Once you understand the pros, cons and costs, you’ll be better equipped to make decisions for your financial future.
Some of the considerations to keep in mind with a 401(k) include:
- Pro: You can place funds into the plan every year.
- Con: You might not be able to save enough.
- Pro: Employers might add to the account.
- Con: Contributions from employers might be minimal.
- Pro: Maintaining the account can be simple.
- Con: Some 401(k)s include higher fees.
- Pro: 401(k)s can help you budget for retirement.
- Con: It can be difficult to access funds early.
- Pro: You’ll save on taxes while working.
- Con: You might pay higher taxes later.
Pro: You Can Place Funds Into the Plan Every Year
You might decide to automate contributions to the plan by setting up a transfer of money from your paycheck into the account each month. You’re allowed to make 401(k) contributions of up to $22,500 of your salary in 2023. If you’re 50 or older, you can put an additional $7,500 into the plan for a total of $30,000.
Con: You Might Not be Able to Save Enough
You might start by contributing less than the limit every year as you pay off other expenses such as student loans. If you’re looking to buy a home or pay off credit card debt, it could be difficult to save as well. Over time, you may be able to move more funds into the account.
If you earn a high salary, you might be looking for a way to save even more than what is allowed in a 401(k). In these cases, you could consider additional investments or savings vehicles, such as stocks, bonds or annuities. You may decide to maintain a 401(k) with your employer, and then build a diversified portfolio to prepare for the future. You could also check to see if your company provides additional retirement benefits or plans for high earners.
Pro: Employers Might Contribute to the Account
Some employers offer to match up to a certain amount of your contributions to the plan. “That’s free money for you,” says Rafael Rubio, president of Stable Retirement Planners in Southfield, Michigan.
Suppose your company’s policies indicate a match of 50 cents for every dollar you save in the plan up to 5% of your salary. If you earn $60,000 a year and contribute $6,000 to the account, your employer will contribute $1,500.
Con: Contributions from Employers Might be Minimal
Not all employers offer a 401(k) match, and even if they do, the match might not seem like much. A match of 50% of your contributions up to $500 would indicate that if you contribute $2,500 to the account, the employer would add $500.
If you’re unsure whether your company provides a match, can check with your employer. If there is a match, it is worthwhile to contribute enough to get the maximum match.
Pro: Maintaining the Account Can Be Simple
When you place funds into the 401(k) plan, you’ll be able to purchase different types of investments. “Plan sponsors traditionally put together a list of 20 to 25 mutual funds, half of which are target-date funds,” says Chris Gure, an investment consultant at Fortress Financial Partners in Raleigh, North Carolina. A target-date fund is a collection of investments designed to grow more conservative over time until a set date in the future. Target-date funds usually coincide with the year that an individual expects to retire. If you’re looking for a streamlined way to plan for retirement, this could be to your advantage.
Con: Some 401(k)s Have Higher Fees
Often, 401(k) plans come with a number of expenses that might include management fees and recordkeeping fees. “Plans are required to distribute fee disclosures annually,” says Julian Schubach, vice president of wealth management at ODI Financial in Lynbrook, New York. Still, it can be difficult to find these communications. “Most participants have no idea what fees they are paying,” Schubach says.
To learn about the costs involved with your 401(k), ask your HR department or plan sponsor to help you decipher the fine print.
Pro: 401(k)s Can Help You Budget for Retirement
As you contribute funds to your account, you’ll be able to monitor the balances of your investments. If you’re over 50, you’ll have a chance to place even more into the plan every year. A financial advisor can work with you to estimate how much you’ll have at retirement. You’ll then be able to think through your income in your post-working years, which also might include funds from Social Security or a part-time job.
Con: It Can Be Difficult to Access Funds Early
When money is placed into your 401(k) account, the plan is designed for the funds to remain there for a long time. “In most circumstances, distributions from a 401(k) plan prior to age 59 1/2 are subject to early withdrawal penalties of 10% plus federal and state income taxes,” says Chance Burroughs, a financial advisor at Manske Wealth Management in Houston. Certain plans allow for a 401(k) loan or hardship withdrawals if you run into a financial emergency. However, if you borrow from the account, you’ll usually have to pay the amount back plus interest within five years.
Pro: You’ll Save on Taxes While Working
When you contribute money to your 401(k) plan, the amount is deducted from your salary. You won’t be taxed on it during the year you make the contribution. If you earn a salary of $100,000 and place $20,000 into a 401(k), your taxable income will be $80,000 for a year. This could give you a tax break, which might enable you to pay for other expenses or save even more.
Con: You Might Pay Higher Taxes Later
With a 401(k), you will have to pay income tax on your contributions and the investment gains when you withdraw funds from the account. “Without knowing for certain how your 401(k) will perform or what the taxes will be in the future, your 401(k) can be a ticking tax time bomb,” Rubio says.
To lower your risk of high taxes, it can be helpful to monitor the account and forecast your upcoming income. Think about your required minimum distributions, which are withdrawals you’ll need to start taking after age 73. You might calculate how much you’ll have to take from the account in retirement. “This will allow you to estimate what tax implications you will have,” Rubio says.
The exercise may also allow you to determine whether to invest more in other accounts like a Roth IRA, which taxes the contributions in the year you make the deposit but not when you withdraw the funds later.