I know almost all of my listeners have heard of 401(k) plans, and a lot of you have them in your retirement portfolios. But while 401(k)s offer a lot of benefits, like anything else, they have downsides too, and you must assess your financial situation carefully before going all-in on a 401(k). This is also for those of you who work for a government or non-profits, so it includes 457’s as well. To make sure you get the most from your plan, I’d like to talk about 401(k) pros and cons with a special focus on the cons because nine in ten Americans are not aware of the downsides of 401(k)s and how they might be better off supplementing their 401(k) with other investment options.
401(k) Plan Pros
Let’s start with the pros.
A 401(k) is basically a savings plan that allows employees to make tax-deductible contributions towards retirement, where money goes straight from your paycheck to the plan before you can lay your hands on it—and that’s a good thing because you learn to make-do with a smaller pay check. So, think of it as a form of forced savings.
What’s neat about this tax deferral is that you get to invest more than if you had to pay taxes on that amount, and you compound this money without paying current tax today, which helps you build a larger nest egg.
But the government always gets its cut, so you have to pay taxes on the distributions when you take them, later in life… hopefully at a lower tax rate than when you made your contributions.
For 2017, your contribution is limited to $18,000; but if you’re age 50 or more, you can make an additional $6,000 in catch-up contributions every year to a maximum of $24,000. So, these are fairly generous and meaningful limits with the intent of helping you build-up for a comfortable retirement.
And remember, it’s elective, not mandatory. Every year, you get to decide how much you want to contribute towards the plan, if at all.
Employer Matching Contributions
Another great feature of these plans is that employers have the option of making contributions to your 401(k). Typically, employers make matching contributions based on the amount you put in. Their match could go anywhere from nothing to 100%.
If your employer offers matching contributions, but you do not have a 401(k) plan setup, you’re missing out on free money. So, I strongly urge you to take advantage of this matching feature.
Curated Investment Options
With 401(k)s, your employer works with a plan administrator and decides what you can invest in. Most plans offer a fairly limited set of 10 to 12 investment options such as mutual funds, ETFs, or index funds, and you can change your investments at least once every quarter.
The upside here is that your 401(k) investment options are tailored to offer a reasonable degree of diversification while focusing on safety and acceptable market risk. This dampens speculation and helps employees stay invested over the long run, which is vital to growing wealth.
Also, employers offer a Plan Document every year that highlights investment options, how often you can change your investments, the fees, and so on. Most companies also hold planning sessions every year for employees; so attend those meetings and stay on top of plan features and changes. And if you ever have questions about your plan, your Human Relations department should be able to help out.
In my list of 401(k) pros and cons, here’s the last pro. The IRS permits early withdrawals from your plan before you reach the age of 59½ but makes you pay a 10 percent penalty on early withdrawals. So dipping into your 401(k) before age 59½ is not a good idea. That said, if you withdraw money for medical expenses or disability, the IRS waives the 10% penalty, which is nice because it gives you liquidity if you face financial hardship.
That covers the major benefits of 401(k) plans. Now let’s talk about the Cons.
Deferred Taxes Do Not Always Work in Your Favor
Let’s start with the tax-deductible feature. While the original intent was that you’d be in a lower income tax bracket when you retire because you won’t be earning as much, this is not always the case. If you’ve done well professionally and have invested well through the years, mandatory retirement withdrawals and other sources of income, such as say rental income from real estate investments, could put you in a higher tax bracket than when you made contributions. As a result, you could pay more in taxes than if you’d simply invested your money after-tax or better yet, in vehicles such as ROTH IRAs where you pay NO tax on future gains. So, the tax benefits of a 401(k) may not always work in your favor, and you could end up shouldering a big tax liability if your portfolio does well and you end up in a higher income bracket than you started, which can often be the case.
Moreover, if the bulk of your savings is in a 401(k) and similar tax-deferred vehicles, that could lead to a situation where most of your future income is taxable. So, after-tax investments have their own benefits.
Here’s an example: Let’s say you are over the age of 70½ and have $2 million in tax deferred assets and $150,000 in assets that have already been taxed on. And say you need $50,000 to live on every year. Now, remember, the government wants the taxes you owe them, so on that $2 million, you will have to withdraw what’s called a Required Minimum Distribution (RMDs) from your tax-deferred retirement accounts. At $2 million, the RMD works out to about $73,000; so now you’re in a situation where you have to withdraw $23,000 that you DON’T need, AND pay taxes on it. So, having too much in tax deferred assets such as 401(k)s doesn’t always work to your advantage. And, in case you’re wondering how I got that $73,000 RMD figure, it’s based on a government formula, and I’ve included a link to it on my website.
It Does Not Always Make Sense to Invest to the Max
It also does not always make sense to invest to the max. You should assess your situation and talk to a knowledgeable financial advisor to see if you should go all-in and invest up to the 401(k) contribution limit or if you should restrict your contribution to just the amount that would get you the full employer matching contribution. But be clear about one thing—make sure you get the entire amount of the employer match because that is free money.
Limited Investment Options
The investments part is a bit of a minefield. For one, the options offered are often too limited and are made up of stodgier and more expensive funds. While stodgy may be good as you’re approaching retirement age, it’s not if you’re young and depending on your age, it may make sense to minimize your 401(k) and direct your monies to where you have more aggressive investment choices.
The other downside is that the plan administrator may direct you to mutual funds they manage or have an interest in, to maximize their own fees and expenses at the expense of your nest egg. This conflict of interest is a major problem with how 401(k)s are administered. A 2013 study by NerdWallet found that 93% of all Americans “dramatically underestimated the total 401(k) fees the average household will pay over a lifetime.” More than half thought lifetime fees would be under $50,000, but the reality is that the average household with two working adults will pay about $150,000 to $200,000 in 401(k) fees over a lifetime.
The good news in all this is that this bad publicity has stirred a move towards lower fees and better investment options, however, 401(k) related fees are still pretty high. So double-check the fees you’ll pay before you sign up.
And, as I always say, make sure any investment you make makes sense for your particular situation, and the same goes with the 401(k). If you have high credit card debt or student loans or need to save for a down-payment on a house, take care of that first. If you do not have at least 4-6 months of your pay in emergency funds, build that up first. Then, after you’ve taken care of the essentials, see if you should open a 401(k).
Finally, remember that bit about hardship withdrawals? You could always tap into investments in after-tax funds without any penalties, but if you mostly put it all in tax-deferred assets, you will have to pay a 10% penalty.
So, think carefully about 401(k) pros and cons, and wisely allocate your funds so you don’t have to pay taxes on all your withdrawals in retirement.
Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph, or marketing piece to make decisions. The information contained herein is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial advisor with questions about your specific needs and circumstances. There are no investment strategies, including diversification, that guarantee a profit or protect against loss. Past performance doesn’t guarantee future results. Equity investing involves market risk, including possible loss of principal. All data quoted in this piece is for informational purposes only, and author does not warrant the accuracy, completeness, timeliness, or any other characteristic of the data. All data are driven from publicly available information and has not been independently verified by the author.