Opher Ganel, Wealth of Geeks
Do I have enough?
Millions of Americans retire each year and begin living off sources of income other than a paycheck. One of the most frequent questions people nearing retirement ask their financial advisor is whether or not their 401(k) savings combined with other investments will be enough to help them enjoy a comfortable retirement.
According to a recent study conducted by RetireOne and Midland National Life Insurance Company, a whopping 82% of surveyed financial advisors reported their clients are fretting about outliving their retirement savings, such as assets held in their 401(k) plan.
Can your 401(k) plan save enough money to make a real difference in how soon you can expect to retire? This is a question on the minds of many people. Is this retirement account offered through their employer 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. With the help of input from financial professionals, I’ll dissect this plan here so you can draw your own conclusions.
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What are 401(k) plans?
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 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.
“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,” said Michael Raimondi, Wealth Manager with Clarus Group. “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.”
Your employer can choose to contribute their own money to your account, too, regardless of your contribution. However, most end up matching your contribution at some level (typically $0.50 per dollar or dollar for dollar up to 6% of your salary).
Your employer determines the investment options in your 401(k). Once you retire and start drawing from your 401(k), withdrawals from non-Roth accounts are taxed at your income tax rate.
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Advantages of 401(k) plans
Traditional and Roth versions of 401(k) plans share many advantages but differ in their taxation.
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 avoidance. When you withdraw money in retirement, it’s included in your taxable income then.
You contribute after-tax dollars for a Roth 401(k), so you don’t save anything on taxes that year. However, all withdrawals in retirement, including returns from your investments, are tax-free.
“A 401(k) plan’s most potent element is removing our impulsive brains from the equation,” Emily C. Rassam, Senior Planner at Archer Investment Management. “401(k) contributions are deducted from our paychecks, often without us noticing or feeling the pain.”
Another advantage is the free money that comes from employer matching contributions. For example, say you earn $100,000 a year, and your employer offers a dollar-for-dollar match of up to 6% of your salary. If you contribute a full 6% ($6000), you get an additional $6000 match, saving $12,000 a year to your 401(k) account.
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).
“401(k) contribution limits are substantially higher than those of IRAs, which can be a game changer for many,” said Blaine Thiederman, CFP, Founder and Principal Advisor at Progress Wealth Management. “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.”
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.
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).
401(k)s also offer a layer of legal protection. 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.
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Drawbacks of 401(k) plans
Most downsides to a 401(k) come from taking the funds out before retirement. If you make an early withdrawal (before age 59.5), the IRS will assess a 10% penalty on top of any taxes you owe on the withdrawn amount. In most cases, this makes your 401(k) assets expensive to access.
Similarly, taking out a 401(k) loan could cause losses. If after you take out the loan, the market happens to rise by 20% by the time you pay it back, and you paid 5% 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.
“401(k)’s biggest risk is that you can take a loan against it,” explained Thiederman. “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.”
“IRAs don’t offer loans, only incredibly expensive withdrawals which can make many shy away from taking out funds,” Thiederman adds.
Your employer can weigh down the quality of a 401(k) too. 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. Also, some employers may not match your contributions much, if at all.
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Personal experience
I once had a 401(k) with an employer match that did depend on my contributions. It had a match that depended on my contributions, which led me to contribute 6%, so I’d get the employer’s maximum 6% match. That gave my returns a huge boost.
From this experience, I can say that employer matching is an incredible benefit. 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).
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Conclusion
401(k) plans are worth it, especially if your employer offers a significant match. Try to max out the match you get. If you make enough that you can spare more for savings than IRAs allow, a 401(k) lets you set aside a lot more into a tax-advantaged account and defer taxes to a retirement that may see you in a lower tax bracket.
