The Advantages and Disadvantages of Traditional 401(k) plans

by Chris Butterworth on August 15, 2011

This article highlights the benefits and drawbacks of participating in a 401(k) plan, a common retirement plan offered by employers to allow employees to save for retirement.

Advantages of a 401(k) plan

1.  Deferred Taxes

There are a lot of advantages to saving for retirement with a 401(k) plan.  The first and most widely cited advantage is deferred taxes.  When you contribute to a 401(k) plan (up to certain contribution limits), your contributions are not counted as income for the purposes of federal income tax.  You still have to pay payroll taxes like Social Security and Medicare, but not having to pay income taxes on these contributions can represent a huge tax savings.  However, the tax man can’t be dodged forever: while contributions are permitted to grow tax free, when you start withdrawing your funds in retirement your distributions are considered taxable income.

2.  Employer matching contributions.

In many cases, employers contribute a certain percentage of an employee’s salary or contributions to their 401(k) plan.  Commonly, as employers have increasingly moved away from pension plans, companies will contribute 3-6% of wages or provide a match of 100% of contributions up to 6% to an employee’s 401(k) plan.  These incentives vary significantly by employer so it’s important to investigate the company’s policy when deciding what level of contributions make sense for you.  If you are contributing 6% of your wages to the plan and your employer offers a 100% matching contributions you are essentially doubling your contributions.  This can really help accelerate saving for retirement.

3.  Automatic savings

The third advantage is that with many plans, payroll deductions provide for automatic savings. This means that if you so choose, your employer will automatically transfer money from your paycheck every pay period based on your agreed upon contributions.  By automating your contributions, it makes it a lot easier to save as the money never hits your bank account.  And because there are strict standards for hardship withdrawals and loans, it is hard to move the funds out of your account.  Automating your savings will help build confidence that you are providing for your future.

4.  Loans

The fourth advantage is the availability of loans in many plans. This means that you are able to get a loan with the money that put into your 401(k) plan if you need it. You can borrow against the money in an emergency comes up in your family.  And when you pay back the loan, you are paying interest to yourself.  While it’s not ideal to take a loan and reduce your retirement savings in the short term, it is comforting to know that you’re paying interest to yourself and not the bank.

5.  Choices

With many plans, you are afforded the ability to choose which vehicles you invest in.  Usually plans will offer a bundle of mutual funds that you are allowed to invest it, but this approach can certainly vary by plan.  While having some degree of flexibility is good, it is also is incumbent on the saver to do some degree of research.  Despite this, most plans will offer balanced funds that make diversification quite easy for the average investor.

Disadvantages of a 401(k) plan

1.  Vesting

Many plans have a feature called vesting that is meant to retain employees.  What this mean is that if you leave the company before your account has fully vested, you will have to forfeit some of the employer contributions made to your account.   Generally, plans allow employees to become fully vested within three to five years, but since plans have the right to determine when employer contributions will become fully vested it’s important to look into your specific plan rules.

2.  Tax Day Will Come Eventually

One of the major disadvantages of a 401(k) plan is that you have to pay taxes on distributions in retirement, unlike with a Roth IRA or Roth 401(k).  If you have a 401(k) you defer taxes in the short term but have to pay them in the long term, whereas with Roth-type plans you pay taxes in the short term but then the taxes are withdrawn tax free.  The key tradeoff here is whether you believe your tax rates will be higher in retirement than they are today, in which case a Roth plan might make more sense.  If you believe that your tax rates will be lower, then deferring taxes to later might make sense for you.  Increasingly, 401(k) plans are being offered with Traditonal and Roth features to provide an employee with the choice of what makes more sense for him.

3.  Contribution Limits

One of the limitations of many retirement plan schemes is contribution limits.  In 2012 for instance, if you are under 50 you are only eligible to contribute up to $17,000 to your 401(k) plan, not including the employer match.  If you are 50 or over, you can make an additional catch up contribution of $5,500.  However, that is the limit – and any contributions above these limits are subject to income taxes in the current tax year.  And contributions above the limits are taxed twice because you ultimately have to pay taxes again on the distributions in retirement.  Despite these limits, 401(k) plans are a great way to make significant headway in your retirement savings.  For instance, check out this scenario:  you’re 30 this year and begin saving $17,000 a year and increase your contributions by 2% per year, your employer matches 25% of your contributions with no maximum, the funds appreciate at 5% per year, and you contribute until you are 62, you will have $2.2 million saved.

4.  No Guaranteed Payouts

With a pension, employees could count on having a fixed income in retirement.   For some plans, employees might get a pension that provided 50% of their top 2 years average pay in exchange for their years of service, so they could count a stable income in retirement.  Unfortunately, there is no guaranteed payout from a 401(k) plan.  While there are often employer contributions, you are responsible for your contributions and investment choices and in many ways your retirement safety net is largely in your hands.  If you neglect to make contributions to your plan, you will directly impact the amount of distributions you will get later.

Hopefully you found this article useful and informative.  These are just some of the advantages and disadvantages that a person can experience with a 401(k) plan.  Leave a comment with any other benefits or drawbacks that you’ve experienced!

 

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