Understanding the Pros and Cons of 401(k) Plans

A 401(k) is a tax-advantaged retirement account that may be available as an employee benefit through your employer. This type of account can help grow your money over time—and your employer might match some or all of your contributions. A 401(k) can help you build your nest egg, but there are some downsides to consider. Whether it’s the right way for you to invest for retirement will depend on the specifics of your workplace retirement plan and your own financial strategy.

Pros of 401(k) Plans

401(k)s Offer Tax Perks

This type of retirement account comes with the following tax benefits, which can bolster your financial health during your working years:

• Contributions are made pretax: The money you put into a 401(k) is taken out by your employer before you pay taxes on it, so it reduces your taxable income.
• Your money grows tax-free: A 401(k) is a tax-deferred retirement account. That means you won’t pay taxes on earnings, dividends, or interest until you withdraw money from the account.

Your Employer Might Contribute to Your 401(k)

A 401(k) match is money your employer kicks into the account—and it’s an employee benefit that can provide free money for retirement. For every dollar you put in, your employer might match that contribution partially or dollar-for-dollar. How much they contribute will depend on the specifics of the plan. According to Fidelity Investments, the average employer 401(k) match is 4.8%.

It Can Put Retirement Saving on Autopilot

Contributions to a 401(k) are typically made through automatic payroll deductions. You specify what percentage of your earnings you want to contribute, then that amount is withheld from your paycheck on a pretax basis and funneled directly into your 401(k). That can take a lot of the legwork out of saving for retirement.

You can choose your 401(k) investments or allow your plan administrator to do it for you based on your expected retirement age. Similarly, your 401(k) might allow you to invest in target-date funds, which automatically rebalance to become less risky as you get closer to retirement.

Cons of 401(k) Plans

Withdrawals Count as Taxable Income

Since 401(k)s are funded with pretax dollars, you’ll be taxed on withdrawals you make in retirement. Your tax bracket will depend on your income and tax-filing status, but it could create a significant tax burden when you’re no longer working—especially if a 401(k) is your primary source of retirement income. What’s more, tapping 401(k) funds before age 59½ will likely result in an extra 10% penalty.

401(k)s Have Contribution Limits

In 2024, you can contribute up to $23,000 to a 401(k). Folks who are 50 and older can tack on an additional $7,500. If you overfund your 401(k), those extra contributions could be subject to double taxation. Since contributions are limited, and withdrawals are taxable, your 401(k) might not be enough to fully fund your retirement.

You Have to Take Required Minimum Distributions

You must begin making annual withdrawals from your 401(k) once you turn 73. These are called required minimum distributions (RMDs)—and failing to comply might land you in hot water with the IRS. That could include a penalty of up to 25% of the amount not withdrawn. Your RMD amount will depend on your 401(k) balance and a life expectancy factor that’s determined by the IRS.

When Should You Invest in a 401(k)?

A 401(k) can be a handy retirement savings tool. The power of stock market investing could help supercharge your nest egg, and you’ll score tax perks along the way. Here are some scenarios where it might make sense to invest in a 401(k):

• You have an employer match: If your employer offers this benefit, consider exhausting your match before investing in other accounts.
• You prefer a hands-off investing method: A 401(k) can be structured as a set-it-and-forget-it retirement account. You may be able to invest in target-date funds that automatically rebalance on their own.
• You want to reduce your taxable income during your working years: Your 401(k) contributions are made pretax, which reduces how much you pay in taxes while you’re working; instead, you’ll pay taxes when you withdraw money in retirement.

When to Consider an IRA Instead

An individual retirement account (IRA) works a little differently than a 401(k). Anyone can open and fund an IRA apart from their employer. There are two main types of IRAs:

• Traditional IRA: Contributions may be tax deductible, and your invested funds will grow on a tax-deferred basis. You’ll be taxed when you withdraw money, and you can expect a 10% early withdrawal penalty if you dip into the account before age 59½. RMDs also apply.
• Roth IRA: This type of retirement account is funded with after-tax dollars. That means you can withdraw your contributions at any time without penalty or taxes. But things may be different if you withdraw Roth IRA gains when you’re younger than 59½ and have had the account for less than five years.

You might opt for an IRA over a 401(k) if:

• You’re self-employed or don’t have access to a workplace retirement plan.
• You want to select your own broker and investments instead of relying on your plan administrator’s options, which may be limited.
• You want more control over when and how you make contributions. With an IRA, for example, you can easily modify your contribution amount and make lump-sum contributions.
• You want to capture the tax benefits of a Roth account but your employer doesn’t offer a Roth 401(k).
• Your workplace 401(k) has high fees.

Just keep in mind that IRAs have much lower contribution limits. In 2024, you can contribute up to $7,000 across all your IRAs (or $8,000 if you’re 50 or older).

Can I Have a 401(k) and an IRA?

It’s possible to have a 401(k) and IRA at the same time. Contributing to a Roth IRA and a 401(k), for example, can provide income diversification in retirement because your Roth distributions will be tax-free.

Learn more >> What’s the Difference Between an IRA and a 401(k)?

The Bottom Line

A 401(k) is an employer-sponsored, tax-friendly retirement account that can make it easier to save for the future—especially if your employer offers to match your contributions. But it’s important to remember that you’ll be taxed on withdrawals in retirement. There are also contribution limits, early withdrawal penalties, RMD requirements, and potential 401(k) fees to consider. Understanding how a 401(k) works can help maximize your long-term savings.

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