The Pros and Cons of 401(k)s

If you’ve worked for a medium or large company, chances are good you’ve heard of or have a 401(k) plan. It’s the most popular retirement savings plan in the U.S. A 401(k) plan is a retirement savings plan sponsored by one’s employer. It allows employees to set aside a percentage of their income to save for retirement, usually through direct deposit. 

Many employees take advantage of employer-sponsored 401(k) plans, but they don’t quite understand how they work, and what their pros and cons are. We’re going to clear that up in this post. We’ll start with the pros. 

Pros of 401(k) plans

The great thing about 401(k)s is that they encourage employees to start saving for retirement now, and they provide a means to do it. To understand why this is such a great benefit, you need to understand that many Americans have either too little or nothing saved for retirement. That means they do not have the means to ever stop working. This is a huge problem, and the 401(k) helps to ensure most employed Americans have a means of saving something. Some employers go a step further than just offering a 410(k). They even match an employee’s contribution up to a certain percentage. 

Another nice feature of the 401(k) is the tax advantage. When employees put part of their earnings into a 401(k), that contribution is not taxed, which reduces their annual taxable income. That money is taxed later when it is withdrawn because—the theory is—when a person is ready to withdraw their 401(k) savings for retirement (starting at 59 ½ ), they will be in a lower tax bracket than when they were in their prime earning years. Therefore, they are taxed less on those contributions overall. 

In addition to the tax advantage, 401(k)s also have high contribution limits: $19,500 per year for people 49 years old and under, and $25,000 per year for those 50 and older. 

Cons of 401(k) plans 

While there are some very strong benefits of 401(k) plans, they are some cons to consider. For example, not every employer offers 401(k) plans, usually due to the high fees. Offering employees 401(k) retirement plans isn’t cheap. 

And 401(k)s are lacking in variety. There are two types—traditional and Roth. Traditional 401(k)s defer taxation until you withdraw from the account, whereas Roth 401(k)s are taxed now. There are different opinions about which is better. Some believe it’s better to be taxed later when you’re out of your prime earning years and in a lower tax bracket. Others think it’s risky to assume you will be in a lower tax bracket when you’re ready to retire or that taxes won’t increase by that time.

Another downside to 401(k)s is the early withdrawal penalty. If you withdraw from your account before age 59 ½ then you will be penalized 10% of the amount you withdrew. Imagine you want to buy a house and you have to withdraw $5,000 from your 401(k) for a down payment—not an ideal scenario, but it happens. To take $5,000, you will pay a $500 fee. Yikes!

The last downside of the 401(k) that I’ll go into is the lack of guidance provided. When you opt into a 401(k), you rarely get any explanation and even more rarely do you get professional guidance. That could mean that you’re putting hard-earned money into a retirement account that isn’t at all optimized. What do you do about that? We recommend seeking out professional guidance. Meet with a financial advisor who can provide better direction about how you can optimize your 401(k) contributions.