Contributing to a 401(k) plan offered by your employer is an easy way to set aside funds for retirement.
These accounts are designed for long-term saving and include some key advantages over other types of investment accounts. However, you’ll want to be aware of the potential downsides of 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.
[Read: How to Take Advantage of 401(k) Catch-Up Contributions.]
Pro: You Can Place Funds Into the Plan Every Year
You can automate contributions to the plan by setting up a money transfer from your paycheck into the account each month. You’re allowed to make 401(k) contributions of up to $23,000 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 $30,500.
Con: You Might Not be Able to Save Enough
You might start by contributing less than the yearly limit as you pay off other expenses, such as student loans. Saving could also be difficult if you’re looking to buy a home or pay off credit card debt. 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, consider additional investments or savings vehicles, such as stocks, bonds or annuities. You can maintain a 401(k) with your employer, and then build a diversified portfolio to prepare for the future. You could also check if your company provides additional retirement benefits or plans for high earners.
[How to Start Investing and Saving for Retirement With Little Money]
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,” said Rafael Rubio, president of Stable Retirement Planners in Southfield, Michigan, in an email.
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.
The Secure 2.0 Act allows employers to match employees’ student loan repayments as 401(k) contributions. You can check to see if your company provides this option and how you might participate if you have student loan debt.
Con: Contributions From Employers Might Be Minimal
Not all employers offer a 401(k) match, and even if they do, it might not seem like much. A match of 50% of your contributions up to $500 would mean that your contribution of $2,500 earns a $500 employee match.
If you’re unsure whether your company provides a match, check with your employer. If there is a match, it may be worthwhile to contribute enough to get the maximum.
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,” said Chris Gure, an investment consultant at Fortress Financial Partners in Raleigh, North Carolina, in an email. A target-date fund is a collection of investments designed to tamp down risk as you near 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 such as management fees and recordkeeping fees. “Plans are required to distribute fee disclosures annually,” said Julian Schubach, senior vice president of wealth management at ODI Financial in Lynbrook, New York, in an email. Still, it can be difficult to find these communications. “Most participants have no idea what fees they are paying,” Schubach said.
To learn about the costs involved with your 401(k), ask your HR department or plan sponsor for help deciphering 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 contribute even more to 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 consider your income in your post-working years, which might also 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,” said Chance Burroughs, a certified financial planner and vice president at Manske Wealth Management in Houston, in an email.
Certain plans allow for a 401(k) loan or hardship withdrawals if you run into a financial emergency. You can make one withdrawal of $1,000 per year to cover a personal or emergency expense without paying the 10% penalty. 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 a traditional 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. Note that a Roth 401(k) allows you to make after-tax contributions.
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 said.
To lower your risk of high taxes, it can be helpful to monitor the account and consider your upcoming income. Think about your required minimum distributions, which are withdrawals you’ll need to start taking after age 73. “This will allow you to estimate what tax implications you will have,” Rubio said.
The exercise also allows you to determine whether to invest more in other accounts like a Roth account, which taxes the contributions in the year you make the deposit but not when you withdraw the funds later.
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Is a 401(k) Worth It in 2024? Pros, Cons and Costs originally appeared on usnews.com
Update 03/14/24: This story was published at an earlier date and has been updated with new information.
