Is a 401(k) plan worth it? This is a question on the minds of many people trying to decide if this retirement account offered through their employer is better than other savings options like an Individual Retirement Account (IRA).
Having invested through 401(k) plans and their 403(b) cousins for a quarter century, I can speak to this from first-hand experience (and do so below).
But it can get complicated, so I figured we’d benefit from a deeper dive to determine if a 401(k) plan is worth it with financial professionals’ invited to share their perspectives.
So, I asked. Their answers are included in this article.
What Are 401(k) Plans and What Are 403(b) Plans?
According to the IRS, “A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts. Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals). Employers can contribute to employees’ accounts. Distributions, including earnings, are includible in taxable income at retirement (except for qualified distributions of designated Roth accounts).”
Translating to English:
A 401(k) is an employment-based retirement plan – you can’t open one unless your employer offers it. If they do, you can choose to contribute money to the plan (up to limits updated by the IRS annually). If your employer’s plan offers a Roth option, you can choose whether you want to contribute after-tax dollars to a Roth account or deduct your contribution in the year it’s made and place it into a traditional account.
Your employer can choose to contribute their own money into your account, too, regardless of your contribution or lack thereof. However, most end up matching your contribution at some level (typically $0.50 to the dollar or dollar for dollar up to 6 percent of your salary).
Your employer determines the investment options in your 401(k), which are usually mutual funds invested in stocks, bonds, or a combination.
Once you retire and start drawing money from your 401(k), withdrawals from non-Roth accounts are taxed at your personal income tax rate.
And a 403(b) plan?
The IRS says, “A 403(b) plan (also called a tax-sheltered annuity or TSA plan) is a retirement plan offered by public schools and certain 501(c)(3) tax-exempt organizations.”
From my perspective and yours, the 403(b) is the same as a 401(k), except that it’s offered by a limited class of employers – mostly public schools and charitable organizations.
How Many Americans Participate in 401(k) Plans and How Much Is Their Total Balance?
Based on data from the Bureau of Labor Statistics (BLS), 51 percent of workers participate in 401(k) plans, and an estimate from the Pew Research Center says there are about 157 million workers in the US; we can estimate that over 80 million Americans are 401(k) participants.
According to Statista, 401(k) plans held a total of $7.3 trillion at the end of the second quarter of 2021. Assuming this figure declined along with the S&P 500’s ~10-percent drop since then and neglecting new investments, that would be about $6.5 trillion today.
The Investment Company Institute (ICI) estimates the total US retirement market assets were $37.5 trillion at the end of the first quarter of 2022. Scaling by the S&P 500’s 16.45-percent loss since that should be about $31.3 trillion now. That means 401(k) assets are about 21 percent of the total US retirement market.
The $6.5-trillion total balance makes the average plan balance across all ages about $100,000. A nice chunk of change, but far from enough to fund a comfortable retirement in the US.
A Vanguard study showed that even for Americans in their 60s or later, the average balance is around $250,000, and the more representative median balance is just over $80,000.
According to Vanguard, if employers make their 401(k) plan opt-in (i.e., you have to actively choose to participate), participation rates are about 28 percent, whereas if they make it the default, those rates rise to 91 percent!
Further, employers who set higher default contribution rates, say 8 percent of salary; set automatic escalation by say 1 percent per year; and pick default investments other than money-market funds, e.g., target-date retirement funds, result in far better participant outcomes.
Now that we know what 401(k) plans are and how many invest how much, it’s time to dive into their savings, risks, and benefits.
The Advantages of 401(k) Plans
Traditional and Roth flavors of 401(k) plans share many advantages, but differ in their taxation.
- Tax benefit: Contributions made to a traditional 401(k) reduce your taxable income in the year you contribute, lowering your tax liability. However, this is tax deferral, not tax avoidance. When you withdraw money in retirement, it’s included in your taxable income then. For a Roth 401(k), you contribute after-tax dollars, so you don’t save anything on taxes that year. However, all withdrawals in retirement, including of returns from your investments, are tax-free.
- No income test for tax benefits: The above tax benefits are available to you no matter your income, which is very different than for IRAs. For IRAs, between $109,000 and $129,000 modified adjusted gross income (MAGI) for joint filers, your deductible contributions to a traditional IRA phase out. If your MAGI is over $204,000 for married filing jointly, your allowed Roth IRA contribution starts to decrease, disappearing at $214,000 MAGI.
- Employer matching: If your employer offers a match, you benefit from free money they contribute to your account. For example, say you earn $100,000 a year, and your employer offers a dollar-for-dollar match up to 6 percent of your salary, contributing 6 percent to maximize the match, your $6000 contribution brings in a $6000 match, adding $12,000 a year to your 401(k) account.
- High(er) contribution limits: As mentioned above, the IRS sets 401(k) contribution limits. In 2022, that limit is $20,500 ($27,000 if you’re 50 or older), much higher than the $6000 IRA contribution limit ($7000 if you’re 50 or older).
Blaine Thiederman MBA, CFP, Founder and Principal Advisor at Progress Wealth Management, calls this the largest benefit of 401(k) plans over IRAs. He says, “401(k) contribution limits are substantially higher than those of IRAs, which can be a game changer for many. If you’re far behind on saving for retirement, make sure your job has a 401(k). If it doesn’t, you’ll likely have a hard time reaching your goals.
“Why do contribution limits matter? Because for every dollar you contribute to a pre-tax 401(k), your income is reduced in the IRS’s eyes, which means less taxes you’ll have to pay right now. This means you can afford to save even more. Many people may end up saving an additional $3-$5k a year because they can afford to when they’re serious about reaching their goals.”
- Automatic savings: Whether your employer follows 401(k) best practices and sets high and escalating default contributions, or they don’t, but you opted in, a portion of each of your paychecks gets added to your retirement investments, helping your future self.
- Ability to access your money in emergencies: The so-called “rule of 55” lets you make penalty-free withdrawals if you’re laid off, fired, or quit after age 55. In addition, many 401(k) plans let you borrow from your balance. You have to pay back what you borrow, but the interest is paid back into your account, so you’re paying yourself. Another possibility is if you can demonstrate an “immediate and heavy financial need,” the IRS will allow a penalty-free (but not tax-free) hardship withdrawal to cover certain qualified expenses (e.g., medical care, funeral costs, and/or college tuition).
- (Some) protection from unsuitable investments and creditors: The Employee Retirement Income Security Act (ERISA) requires your employer to be a fiduciary in the 401(k) plan, so they have to act in your best interest. This means they’ll pick solid investment options rather than risky or overly expensive options. Further, ERISA protects balances in your 401(k) account from creditors. Note, however, that you’re not protected from the government…
- Access to institutional share classes: If you invest in a mutual fund through an individual account (IRA or taxable), you will most likely not have access to institutional-class shares that come with lower management fees. Through a 401(k) plan, you may well benefit from those.
Risks and Drawbacks of 401(k) Plans
- Early withdrawal penalties: If you make an early withdrawal (before age 59.5), the IRS will assess a 10-percent penalty on top of any taxes you owe on the withdrawn amount (no tax for a Roth account). In most cases, this makes your 401(k) assets expensive to access.
- Taxation issues: Contributions to a traditional 401(k) reduce your taxable income when you make them. In return, you’re taxed on withdrawals in retirement. At first glance, that looks like a win, but… Whereas a taxable portfolio could be invested in, e.g., individual stocks where gains will only be taxed at lower capital gain rates, and even only when you sell a holding, withdrawals from a 401(k) are taxed at your personal income tax rates.
- Loan gotchas: If you take out a 401(k) loan, the market happens to rise by 20 percent by the time you pay it back, and you paid 5 percent interest, you just robbed yourself of most of the return you would have had on the amount you borrowed. Also, if you take out a 401(k) loan and leave your job before paying it back, you have a short period of time to repay the loan, or the IRS will consider it an early withdrawal.
Blaine Thiederman says, “401(k)’s biggest risk is that you can take a loan against it. This can be a benefit for some, but for many, it hampers their ability to reach their goals because when you take a 401(k) loan, the dollar amount of the funds borrowed are sold out of the markets. This means your funds aren’t invested and growing, which can cost you a lot of money.
“You’ll often see people who use 401(k) loans as repeat offenders. They use them again and again, seeing them as an option to help get through tough times. Typically, they don’t use a budget, have large amounts of credit card debt, and have little strategy for managing their spending and saving. Their strategy to reach financial freedom is essentially based on a hope and a dream, and that’s no good.
“IRAs don’t offer loans, only incredibly expensive withdrawals which can make many shy away from taking out funds.“
- Limited investment options: Since employers are fiduciaries, they pick a limited set of investment options, sometimes all from one family of mutual funds, which is unlikely to include all the funds you would have chosen for yourself.
- Employers may not match your contributions much, if at all: Since employer matching is voluntary, your employer may not offer much, if any, matching of your contribution.
- You bear all the investment risk: This is true for all other investment options but would not be true for a pension (if you’re lucky enough to have that option) or annuity. Emily C. Rassam, CFP®, AIFA®, CRPS®, NSSA, Senior Planner at Archer Investment Management speaks to these investment risks, “401(k), IRA, and taxable accounts are all empty containers that you can fill with whichever investments are available. The investment risk is then attributed to the individual selection of investments inside each such bucket. You can tilt any of the three account types into more aggressive or conservative investments based on your risk tolerance. There’s a concept called asset location or tax location, which can help strategize which types of investments are best suited for each bucket. For example, you may decide to allocate your more growth-oriented assets in your Roth 401(k) or Roth IRA and your more tax-efficient investments in your taxable brokerage account.”
My Personal Experience with 401(k) and 403(b) Plans
My first job in the US came with a pension (really!). But leaving after just five years meant I didn’t get much mileage out of it. I just rolled the balance over into an IRA when I left.
My next job came with a 403(b) plan. Knowing I could invest as I see fit appealed to me more than the annuity alternative. And did I mention my employer contributed 7.25 percent of my salary regardless of whether I contributed anything? Unfortunately, my salary left next to nothing for savings, so 7.25 percent was all that went into my plan. Again, when I left, I rolled the balance over into another IRA.
My next job had a 401(k) with an employer match that did depend on my contributions (more on that later). Interestingly, having a match that depended on my contributions (and having a salary more than twice as high) led me to contribute 6 percent, so I’d get the employer’s maximum 6 percent match. Once more, when I left this position to start my own business, I rolled the balance over into yet another IRA.
In none of these plans did I have access to my preferred mutual funds – from T. Rowe Price. Still, the employer matching gave my effective returns a huge boost.
These days, being self-employed, I have a solo 401(k), which let me pick T. Rowe Price as the provider. Here, I get the best of both worlds (though as my own employer I have to cover my own employer matching).
From this experience, I can say that employer matching is an incredible benefit, especially when your income is limited as mine was when I participated in a 403(b). If and when you can open a solo 401(k) as your own employer, that benefit disappears. However, at that point, the high contribution limits become the driving benefit of a 401(k). When you’re starting out, and your income isn’t very high, the contribution limit of an IRA may be more than enough relative to what you can afford to set aside.
The Bottom Line – Are 401(k) Plans Worth It and Who Benefits Most from 401(k) Plans, IRAs, and Taxable Portfolios?
As should be clear from the above, 401(k) plans are most definitely worth it if you can benefit from their advantages. If your employer offers a significant match, you should almost definitely take advantage and maximize the match you get. If you make enough that you can spare more for savings than IRAs allow (or so much that you can’t deduct traditional IRA contributions or even make Roth IRA contributions), a 401(k) lets you set aside a lot more into a tax-advantaged account(see Thiederman’s comment below), and (if not a Roth plan) defer taxes to a retirement that may see you in a lower tax bracket. The financial pros I asked shared other important points.
Emily Rassam points out, “A 401(k) plan’s most potent element is removing our impulsive brains from the equation. The more automated we can make our savings habits, the more we accumulate over time. 401(k) contributions are deducted from our paychecks, often without us noticing or feeling the pain. IRAs often require a conscious effort to save, and it’s tempting to delay or reduce our IRA savings when other budgetary demands come up. The best time to increase your 401(k) savings rate is when you get a raise. If your pay rises 3 percent annually and you increase your 401(k) savings rate by 1 percent each year, it’s a win-win scenario. Your take-home pay increases by 2 percent, and your 401(k) savings rate is 1 percent higher. Repeat this for a decade or more, and you will have a significant savings rate without your take-home pay ever going down.”
She adds, “Taxable accounts are well suited for clients seeking the most spending flexibility or if they’re saving towards a short-term or intermediate-term goal. 401(k) plans and IRAs carry more restrictions and potential penalties for early withdrawal. If you’re mainly saving for retirement, we recommend maxing out your 401(k), then saving in an IRA, then sending additional funding to a taxable account.”
Thiederman says, “The people who would benefit most from contributing pre-tax into a 401(k) are high-income earners who make far more than they need to live a decent life. IRAs benefit W2 employees who don’t have access to a 401(k) because their employer doesn’t offer one. Taxable accounts benefit most of those who already maxed out all their tax-advantaged retirement accounts and still have additional funds to save and/or have short-term financial goals like buying a house in the next 3-5 years, and the penalties are too large to justify them saving in a tax-advantaged account like an IRA or Roth IRA.”
Michael Raimondi, Wealth Manager with Clarus Group, says, “401(k) plans are worth it when it comes to diversifying your assets, especially their location and allocation. 401(k) plans can help reduce your taxable income on their own or in conjunction with a traditional IRA, not to mention a possible employer match you want to ensure you’re maximizing. Many employers also now offer Roth 401(k) plans, so further diversification is available to take advantage of post-tax retirement savings under a qualified plan. For the self-employed, it may be wise to consider a solo 401(k), as opposed to a SEP IRA, if you are a single-person business. Depending on your income, solo 401(k) plans can potentially allow you to save more by allowing employee and employer contributions, while SEP IRAs allow annual contributions of 25 percent of salary up to $61,000. Catch-up contributions are one of the real draws for the 401(k), allowing employees over 50 to make an additional $6,500 contribution in 2022. IRAs allow just a $1,000 annual catch-up contribution. Making significant contributions to retirement accounts early on in one’s career builds a habit that pays through compounding interest and market growth over the years. Time is money’s best friend. Our future selves will thank us for it.”
A Closing Thought
As a final note, taxable accounts may also be very beneficial if you don’t get matching from your employer and are comfortable picking individual stocks and holding them for Warren Buffett’s favorite investing horizon – “Forever.” This lets you benefit from long-term appreciation, paying taxes only when you sell (if ever), and even then, paying the preferential long-term capital gains tax rate.
This article originally appeared on Wealthtender.com and was syndicated by MediaFeed.org.
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How the 4% retirement rule works
As people prepare for their retirement years, many put away money. And, for those who do, when they retire, the question may be how much can be safely taken out each year without depleting funds for the years yet to come.
Financial professionals often give their clients recommendations about that topic, and the 4% rule is an example of what one expert determined to be a historically safe annual withdrawal amount. “Safe” in this context means that, by withdrawing that amount, retirees would have a flow of monthly income while still preserving some of the principal balance of their retirement funds.
Because the withdrawals would at least partly consist of dividends and interest that continue to accrue, the entire amount withdrawn each year would not totally come out of the principal balance.
So, when deciding what to withdraw annually, is this rule still considered accurate, or at least useful for a reasonable number of people?
This post will explore this rule in more depth, including how it originated, misconceptions some people have about the rule, the potential risks associated with it and whether it’s still a viable strategy today — along with strategies to build up balances in retirement accounts.
Related: Retirement savings: which retirement plan is right for you?
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William “Bill” Bengen conducted a study and published his results in 1994. From this study came the 4% rule.
Bengen took investment data that began in 1926. He then used this historical data to determine the maximum initial withdrawal amount that could sustainably be taken out for each rolling 30-year time frame. In each data set, he calculated the worst and best scenarios that could occur.
Out of these true-to-life scenarios, he determined that the 30-year period beginning in May 1965 was a worst-case scenario, one where a $1 million portfolio could only have a $40,700 initial withdrawal.
Contrast that with the best scenario, which began in August 1982 — and which had an initial withdrawal of $112,900 from the same size portfolio — and you can see the range of his results based on time frames.
Because this withdrawal percentage is based on what has happened in the past, this may or may not accurately predict what will happen now and in the future. Sometimes the rule is being referred to as the 4.5% rule.
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In Bengen’s calculations, he was not determining a percentage that would help to ensure that someone’s retirement savings would last a lifetime, no matter how many years they lived, post-retirement. Instead, he was calculating what withdrawal level would cause retirement funds to last for 30 years.
Another common misconception focuses on how to calculate the 4%, with some people believing that the percentage should be calculated each year at the current principal balance. Instead, it should only be calculated one time, based upon the principal balance of the retirement funds when the person first retires.
So, if the balance was $500,000 at the point of retirement, then the maximum annual withdrawals would be $20,000. If the starting balance was $1 million, then it would be $40,000, and so forth.
Here are two more things to consider. Bengen used sample portfolios that contained 50% stocks and 50% bonds.
Portfolios with different investments and percentages of them would likely have different results, depending upon the levels of risk inherent in those portfolios.
And, because success was defined as having money left over after 30 years — meaning, any money whatsoever — Bengen’s definition of success may not match that of a retiree. For example, if, after 30 years, a retiree had $10 left in a retirement fund, then the 4% (or 4.5%) rule would be considered a success under these parameters.
Would a retiree who might live five years longer (or more!) without any more money to withdraw consider this successful management of the funds?
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One challenge associated with this rule, as noted above, is that it only addresses 30 years’ worth of time. So, if someone’s life expectancy goes beyond 30 years post-retirement, it could pose financial challenges.
Other challenges can exist for retirees who have chosen investments that have higher risks than average ones.
In that case, they may need to take a more conservative withdrawal approach, particularly in the years immediately following their retirement because a market downturn could hit these portfolios harder than what’s typical.
Plus, when retirees take a larger withdrawal, especially early on, this lowers the principal in a way that will affect compound interest throughout retirement years. If this happens, then the retiree can’t simply pick up with the 4% rule from that point on.
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Some financial professionals believe that the 4% rule is actually too conservative, as long as the United States doesn’t experience a significant economic depression. Because of that, retirees may be too frugal with their retirement funds and not necessarily live life as fully as they could.
Plus, some say, this rule doesn’t take into account any other sources of income retirees may have to rely upon, such as Social Security or company pensions.
So, what’s the right withdrawal strategy to take? What’s important is to create a retirement savings plan that takes into account the unique goals of the person, and to focus on building up a significant enough account, balance-wise, to help retirees live their lifestyles of choice.
Here are strategies to consider.
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When considering the best time to start investing for retirement, just about every financial advisor would say to start right now. This can be challenging if, say, someone is trying to pay down student loans or save up for a down payment for a house.
But, starting sooner rather than later can make a huge difference in accumulating savings, perhaps hundreds of thousands of dollars of a difference.
It can also help to understand the different types of retirement accounts available; who they’re available to; and their tax consequences. (Note: This is not tax advice, and you should consult with a tax advisor regarding taxing on retirement plans.) Retirement fund types include the following:
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With a workplace plan, employees typically contribute part of a paycheck, using pre-tax dollars, up to $19,000 per year into their retirement account. Companies sometimes offer a “match,” which means that the employee’s contribution gets matched up to a certain percent by the employer. The match is more or less free money. This account is tax deferred, meaning no taxes are paid on the funds until they are withdrawn. Withdrawing these funds early, though, could trigger a 10% penalty along with the income tax consequences.
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These are retirement fund options for people who are self-employed.
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This is a tax-deferred retirement account, one that’s not tied to the workplace. So, this is also an option used by freelancers and other self-employed people, as well as people who don’t have 401(k) accounts at work. Contribution limits for people under age 50 are capped at $6,000 annually; those who are 50 or older can contribute up to $7,000 each year. This account also has a penalty for early withdrawal.
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This is another form of retirement account that’s not connected to the workplace, and contribution limits are $6,000 annually. The taxation system for a Roth IRA, however, is different, with income taxes paid on contributed money. In other words, this is not a tax deferred account like a traditional IRA is. But, when retirees withdraw funds, the money is not taxed. Not everyone qualifies for a Roth (there are income limits) but it can be open to people who are employed by a company as well as those who are self-employed.
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If it seems challenging to save for retirement, given your other expenses, here are a few tips.
A good first step is to create a budget that works for the person’s income and expenses, and includes contributions to a retirement account.
This should be a reasonable budget — meaning that it’s realistic, one that can be adhered to. It makes sense to review this budget regularly, perhaps every few months, and adjust as needed.
In situations where employers offer a 401(k) program and then match contributions, then it can be a wise move to participate in this program. Matches, remember, are essentially free cash.
What expenses can be cut back to make room for higher contributions? Are there online subscriptions or fee-based apps that can be canceled? Are better prices available for cell phone plans? Insurance policies?
Can credit cards be consolidated into a lower-rate personal loan? Once a credit card bill or personal loan is paid off, what about putting the money that was being put towards payments into the retirement account?
What about getting a side gig? People with special skills, such as photography, copyediting, cooking and more can earn extra money outside of their main jobs, and these funds can go towards retirement contributions.
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At a high level, the 4% rule states a percentage that retirees are said to be able to withdraw annually and still have the funds last for 30 years. For example, someone could withdraw $20,000 a year with a $500,000 retirement fund balance.
But, here’s a question that the rule doesn’t address. Is $20,000 enough for someone to live the desired lifestyle during retirement years? Is $40,000 enough? $60,000? What is the right amount?
Different people have different dreams for retirement. Some want to travel the world, while others want to spend time with family at home. Some may have other financial responsibilities, like potentially helping a grandchild pay for college. What matters most is that each person plans for the retirement they expect and/or want to experience.
What about having a 401(k) and an IRA? Is that possible? If it’s possible, does it make sense?
Well, for people who have retirement plans through work that include matching funds, it can often make the most sense to take as much advantage of that matching benefit as possible. And, once the 401(k) is maxed out, if more funds are available, it may make sense to contribute to a traditional IRA.
Here’s something else to consider. Once investors reach their annual limits for retirement contributions, that doesn’t mean they need to stop investing money to enjoy during their retirement years.
This can happen through using brokerage accounts for retirement planning. Although they won’t have the same tax advantages as, say, a traditional IRA, this does allow people to keep investing and building wealth.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA/SIPC. The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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