Opher Ganel, Wealth of Geeks
In 2024, the Internal Revenue Service will permit individuals to contribute $23,000 to their 401(k) plan, up from $22,500 in 2023. But can the average American expect to enjoy a comfortable retirement based on their 401(k) contributions throughout their career alone?
With so much financial uncertainty, it’s worth taking a closer look at the savings vehicles used to prepare for retirement. According to the Bureau of Labor Statistics, with 51 percent of workers participating, there is none more popular than the 401(k).
A 401(k) is a retirement plan only available to individuals through their employer. If an employer offers a 401(k) plan, employees can decide to put some of their money into it, up to the annual limit set by the IRS. There may be two 401(k) plans to choose from, a traditional or Roth. The biggest difference is in how taxes are paid on the money contributed and when the employee is taxed.
If the employer offers a Roth option, employees can choose this option and put in money after they’ve already paid taxes on it so there’s no penalty at withdrawal. Alternatively, with a traditional 401(k), they add money before it’s taxed for a break that year, and pay taxes on it when they withdraw from the 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,” explains 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.”
Employers can also contribute their own money to employee accounts, regardless of employee contributions. However, most companies end up matching employee contributions at some level, often at $.50 to the dollar or a dollar-for-dollar rate of up to 6 percent of the employee’s salary.
Employers determine the investment options in your 401(k). Once employees retire and start drawing from their 401(k), withdrawals from non-Roth accounts are taxed at an employee’s income tax rate.
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The benefits of tax-deferral
Traditional and Roth versions of 401(k) plans share many advantages but differ in their taxation.
Contributions made to a traditional 401(k) reduce taxable income, however, this is tax deferral, not avoidance. When money is withdrawn at retirement, the distributions are included in taxable income.
For a Roth 401(k), employees contribute after-tax dollars, foregoing any tax savings in that year. However, all withdrawals in retirement, including returns from investments, are tax-free.
“A 401(k) plan’s most potent element is removing our impulsive brains from the equation,” says 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, a worker earns $100,000 a year, and their employer offers a dollar-for-dollar match of up to 6 percent of their salary. If the employee contributes a full 6 percent ($6,000), they get an additional $6,000 match, saving $12,000 a year to their 401(k) account.
However, the IRS sets 401(k) contribution limits. In 2024, that limit is increasing to $23,000 ($30,500 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,” shares 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 people make penalty-free withdrawals if they’re laid off, fired, or quit after age 55. In addition, many 401(k) plans let employees borrow from their balance. Workers have to pay back what they borrow, but the interest is paid back into their account.
If employees 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, such as medical care, funeral costs, and/or college tuition.
A 401(k) also offers a layer of legal protection. The Employee Retirement Income Security Act (ERISA) requires employers to be fiduciaries in the 401(k) plan, so they have to act in the best interest of employees. This means they’ll strive to pick solid investment options rather than risky or overly expensive options. Further, ERISA protects balances in 401(k) accounts 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 employees make an early withdrawal (before age 59.5), the IRS will assess a 10 percent penalty on top of any taxes owed on the withdrawn amount. In most cases, this makes 401(k) assets expensive to access.
Similarly, taking out a 401(k) loan could cause losses. If after an employee takes out the loan the market happens to rise by 20 percent by the time it is paid back, and assuming they paid 5 percent interest, the employee will have lost most of the return they would have earned on the amount they borrowed.
Also, if employees take out a 401(k) loan and leave their jobs before paying it back, they 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,” says 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.
Employers can weigh down the quality of a 401(k) too. Since employers are fiduciaries, they pick a limited set of investment options. Sometimes, they’re all from one family of mutual funds, which is unlikely to include all the funds individuals would have chosen on their own. Also, some employers may not match employee contributions much, if at all.
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The value of matching contributions
401(k) plans are worth it, especially when employers offer a significant matching contribution. Americans will do their best to try and max out the match they receive, though it is recommended to speak with a financial advisor for guidance on which investments to choose.
For those who make enough and can spare more for savings than IRAs allow, a 401(k) offers an opportunity to save a significant amount in a tax-advantaged account and defer taxes until retirement, potentially in a lower tax bracket.
