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.
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