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401(k) plans were introduced to encourage employees to save enough money for life after retirement. According to new research, approximately 82% of employees already save for retirement in a 401(k) plan. The main reason people now save is that they are aware of what happens if you don’t save for retirement. If you’re among the few employees not taking advantage of retirement savings and lowering your income tax, here are a few 401(k) advantages and disadvantages to get you started.
401(k) plans lower your taxable income. They offer legal protection for your investments and encourage employer contributions so that you can accumulate enough money for your retirement. On the downside, employees have to deal with limited investment options and hefty penalties for early withdrawal.
If you’re thinking about getting started with a 401(k) plan (or its alternatives such as Individual Retirement Accounts (IRAs) and 403b plans), read on for more detailed information about the advantages and disadvantages of 401(k) plans for employees.
Recap: What a 401(k) Plan Is and Isn’t
You’ve probably heard a lot about 401(k) plans and how they can contribute to your financial status after retirement.
A 401(k) is a retirement savings plan based on the Internal Revenue Service Code section 401(k). An employee who enrolls in an employer-sponsored 401(k) plan agrees to have some part of their paycheck deducted and saved in a 401(k) account before or after-tax deductions. The deducted amounts (contributions) go into the 401(k) plan.
The employee can choose to put the deducted amount in the investment choices and options provided by the employer, such as mutual funds, stocks, and bonds.
Note: A 401(k) plan is not the same as an Individual Retirement Account (IRA). Although both accounts have the same roots – retirement savings – an IRA does not require the employer’s involvement. Additionally, IRAs tend to have more investment options than 401(k) plans.
Here are the 401(k) advantages and disadvantages:
Tax Deduction (Lower Taxable Income and the Saver’s Credit)
Perhaps one of the most inherent advantages of 401(k) plans is their ability to lower tax liability and the taxable income for the year. 401(k) plans can lower your taxes in three main ways:
- Lower income taxes and taxable income with the traditional 401(k) workplace retirement plans
- Tax-free withdrawals with the Roth 401(k) plans
- Tax reduction through the Saver’s Credit
Lower Taxable Income With the Traditional 401(k)
With a traditional 401(k) plan, the employee’s contributions are deducted on a pre-tax basis (before the IRS takes a tax cut).
Assuming that you have a salary of $45,000 and you dedicate 5% of that into your 401(k) plan.
You can calculate your total taxable income as follows:
(5/100) x 45,000 = $2250
Taxable income = $45,000 – $2250 = $42,750
A 401(k) plan allows employees to set aside part of their gross income before taxes. This is not to say that the IRS won’t tax the money. But instead of paying taxes on the contributions upfront, the employee enjoys deferred taxes. The contributions will be taxed when the employee starts making withdrawals, ideally when they have stopped working and are no longer in a higher tax bracket.
You will not be taxed on interest earnings with tax-deferred 401(k) plans. Earnings on interest with a bank are usually taxed every year. With a 401(k) plan, you are not taxed until you start making withdrawals. Traditional 401(k) plans have a 3% – 8% average annual return depending on your chosen investment options.
Tax-Free Withdrawals With Roth 401(k) Plans
Traditional 401(k)s reduce taxable income, but Roth 401(k) plans eliminate taxes on withdrawals from your retirement account. Contributions in Roth 401(k) plans are made after taxes. This means that every Roth 401(k) contribution has already been taxed, and the government can’t tax the money again. You pay taxes and pay tax upfront before you make the contribution into the qualified account.
So, any withdrawals on a Roth 401(k) plan will not be taxed provided that you hold the account for at least five years and that you’re aged at least 59 ½ years at the time of withdrawal.
Tax Reduction Through the Saver’s Credit
The Saver’s Credit is one of the lesser-known but greater advantages of saving money in your retirement account. It is available to qualified employees who save for their retirement on traditional and Roth 401(k) plans and IRAs. The Saver’s Credit offers an income tax break to individuals and married couples saving for retirement. It can put their annual taxable income in a lower tax bracket on their tax return.
To claim the Saver’s Credit, the employee must meet these minimum requirements:
- Must be above 18 years
- Must meet the maximum adjusted gross income as follows: $49,500 for household head, $66,000 for a married couple, and $33,000 for other ordinary taxpayers
- Must not be a full-time student
- Must not be a claimed dependent on another person’s tax returns
- Must make contributions on the tax year of filing the annual returns
The Saver’s Credit is worth 10%, 20%, or 50%, offering huge tax advantages depending on the person’s income.
If you’d like to know more about the Saver’s Credit, check out the video below:
Legal Protection With the ERISA Act of 1974
Besides saving enough money for future retirement, 401(k) plan investors enjoy legal protection with the ERISA Act. The Act was introduced on September 2nd, 1974 and has since been amended multiple times to match the needs of the employees. Currently, it covers about 684,000 retirement plans, health, and welfare benefits for over 80% of the working population in the United States.
The main purpose of the ERISA plan is to set out the standards of conduct for retirement plan managers. It protects the retirement plans from mismanagement. The Act also ensures that those with a retirement savings plan receive their benefits regardless of the company’s financial status.
Essentially, the ERISA Act protects the plans from mismanagement by the people put in charge of the management of those plans. The Act also promotes accountability and transparency to ensure that the employees have all the information about these plans, including information about the benefits. There is also a claims and appeals process available if your employer-sponsored retirement plan is mismanaged.
What the ERISA Act Covers
401(k) workplace retirement plans fall under ERISA. However, the Act does not apply to government employee pension plans and solo 401(k) plans. For the employee to enjoy ERISA protection, they need to have an employer-sponsored 401(k). ERISA does not also cover plans sponsored by churches, 403(b) plans, IRAs, or simplified employee pensions.
The ERISA Act also protects qualified retirement accounts from creditors. For instance:
You have a job that allows you to contribute 3% of your paycheck to a 401(k) plan. If you decide to draw a loan against your assets and fail to pay after losing your job, the creditor will try all means to recover their money if they get a ruling against you. That’s where the ERISA protection comes in.
The creditor can recover their money from other assets but not from your retirement 401(k) savings.
Employer Contribution to the Account (Employer Matching)
More than half the employers in the US offer 401(k) plans. Although not mandatory, most employers offer to boost your contributions based on your total personal contribution to the account.
Many employers offer contributions to an employee who dedicates a certain amount to their retirement savings with the first paycheck. Others require the employee to work for the company for one, two, three, or five years to get substantial contributions.
There are several options for employer matching, including:
- Fixed match, also; Dollar-for-dollar matching (100% employer match)
- Blanket contribution for all employees
- Contribution percentage match
The employer may opt to contribute 50 cents on the dollar up to 6% of the employee’s pay. They can also go for the dollar-for-dollar contribution for up to 3% of the employee’s income. Other employers will use a multi-tier formula; for example, they can contribute 50 cents for every dollar on the employee’s first 3% of the paycheck and a fixed match for every dollar on the second 3%.
The total amount that will end up in your account depends on the employer’s match, the investment options available, and how the plans are managed. Employees in a 401(k) plan are advised to pick the best investment with the lowest risk and the lowest fees.
Note: The higher the personal contribution, the higher the employer’s match. Expert financial advisors will always recommend saving the highest contributions to get a higher employer match.
Flexible Contribution Limits
High contributions mean more money for retirement. With flexible contribution limits, the employee has more control over how much they can save up to a certain limit. The IRS imposed these limits to ensure that no employee gets favored by the tax burden, especially if they’re highly paid.
However, if you are a lower-earning individual and want to set aside the maximum contribution every year, you will have to practice living below your means. Your paychecks might not be enough to cover day-to-day expenses.
Note, however, employer and employee contributions are not unlimited. For example, you cannot contribute all your salary to your 401(k). Similarly, the employer cannot offer an unlimited matching contribution to your account. All contributions are subject to IRS limits.
In 2021, employees can contribute a maximum of $19,500 if they’re aged below 50. In 2022, employees aged below 50 will be able to save $20,500. There is a catchup contribution of $6500 for employees aged 50 and above in 2021 and 2022.
Remember, you are not entitled to an employer’s match. Employers often offer 401(k) plans accompanied by matching contributions, although this is voluntary.
More Money for the Future
401(k) plans are savings on top of what you might have put in other savings accounts. All savings attract some interest or rewards over time. The earlier you start saving in a 401(k) account, the more money you accumulate over the years. You’ll receive investment earnings over time to secure retirement and help achieve financial goals.
Even if you start investing and saving late, it can still benefit your financial situation when it comes to retirement. A financial advisor can detail how to retire on 500k with proper personal finance management.
Disadvantages of 401(K) Plans to Employees
We’ve seen how 401(k) plans can benefit employees. Unfortunately, these retirement plans also have a few drawbacks worth looking into if you’re planning on signing up for one with your employer.
Hefty Penalties for Early Withdrawals
We strongly recommend that you avoid early withdrawals because they’re very costly in the long run. Technically, you CAN withdraw from your 401(k) plan whenever you want. But this is only going to cost more in penalties that are not worth paying.
The IRS allows people to withdraw free of charge (depending on whether you have a Roth or traditional 401(k) plan) from the age of 59 ½. Anything less counts as an early withdrawal that attracts a 10% penalty the next time you file your tax returns. Early withdrawal penalties are one of the major disadvantages when it comes to future withdrawals.
If you live with a disability and can prove it, you can withdraw the money without the 10% penalty. So, unless you’re 59 ½, have a disability, or, in a dire situation, it would be best to seek other cash alternatives. Find a quick-paying job or borrow soft, low-interest loans from your bank, friends, or family.
Limited Investment Options
401(k)s offer a number of investment choices and options to which the employee can allocate their contributions. These could be:
- Mutual funds
- Money market funds
- Company stock
- exchange-traded funds (ETFs)
The list goes on.
With a traditional 401(k) plan, the employee can only invest in the options listed by the employer. Limited investment options are a concern because the overall success of the plan boils down to the assets you allocate your money to and the actual amount of money allocated to these assets.
For more flexible options, consider supplementing your 401(k) plan with an individual retirement account. IRAs provide dozens of investment options to choose from.
The IRS limits both employer and employee contributions in response to the general rise and fall of prices in the economy. The limit for employer-sponsored retirement plans and employee contributions in 401(k) plans is:
- For those under 50 years, the total contributions should not go beyond $58,000 in 2021. For those over 50 years, the total contribution should not be over $64,500.
- In the year 2022, the contribution limit fit for both employees aged under 50 is capped at $61,000 per year. For those aged above 50, the limit plus catchup contributions stand at $67,500.
Limiting contributions weakens the highly-paid employee’s ability to make the most out of their retirement accounts. After all, people need to save more to get a higher match as well as contribute more to their accounts.
Not Suitable for Emergency Withdrawals
Normally, it takes between 3-10 business days to receive your money after a withdrawal from your retirement savings. If you’re having an emergency, the money from your retirement account might not be useful if you don’t receive it early enough. Don’t forget about the 10% penalty, which comes whenever you withdraw early (regardless of the emergency).
Before withdrawing money from your premature retirement account, you might want to consider other quick cash options, e.g., short-term bank loans borrowing from friends and family.
Returns Risk at Withdrawl
People who have 401(k) plans and start withdrawals in their late 60s and 70s are exposed to risk. They might get a low return on their portfolio because of the sequence of returns risk. This is rather worrying because it’s not too late to withdraw your money, but you might end up with less than what you expected.
How To Take Advantage of Your 401(k)
A little background knowledge about your 401(k) plan may not be enough to help you get the most out of it. You need to put in some effort by finding out whether the employer offers other benefits, learning about the various types of investment options available, and contributing as much as possible.
Here are a few ways to take full advantage of your 401(k).
- Choose your investment options wisely.
- Take advantage of the company match.
- Increase your savings rate gradually.
Choose Your Investment Options Wisely
Investment options offered by your employer will have a significant impact on your account’s ability to grow and the amount of money you’ll have during retirement. Some of the investment options include mutual funds (most common), stocks, bonds, and other assets in brokerage accounts. It is your duty to choose an investment option that suits your needs.
Otherwise, the employer may choose one for you from the options approved by the federal government. Avoid investments with little returns and high fees. These could have a downturn on your account over the years. Choose the lowest-cost options with tolerable risks.
Take Advantage of the Company Match
Most people underestimate the company match and profit-sharing feature. Therefore, they leave out tons of “free money.” Find out how much the employer is willing to contribute to your account and do whatever it takes to get the highest employer contribution. For instance, if they offer higher rates for higher savings, feed your retirement account as much money as you can.
Increase Your Savings Rate Gradually
Employers who offer 401(k) plans have a default rate. For instance, many employers will sign up their employees for a 3% contribution by default. BUT you want to contribute the most out of your paycheck. While saving 3% of your salary is better than nothing, it might not be enough for your planned future.
You can gradually increase your rate by 1% per year. After 15 years, you will be saving more money in your retirement account.
How Much Can I Borrow From My 401k Retirement Plan?
You can borrow up to 50 percent of your 401(k) account balance, but you must repay the loan in two years. If you don’t, the amount loaned will become a withdrawal. You’ll owe taxes on it and an additional 10% penalty tax if you are under age 59 1/2 because this is now considered early distribution. The interest rate for these types of loans is usually fairly low, around prime plus one or two percentage points.
Is It Possible to Take a Home Equity Loan Against Your 401(K) Retirement Savings?
Yes, you can take a home equity loan against your 401(k) retirement savings. This might be an attractive option because the interest rate for a home equity loan is usually much lower than the interest rate on a credit card or other type of personal loan.
When is it Too Late to Start Saving for Retirement?
It’s never too late to start saving for retirement. Whether you are 25, 45 or 55, if your employer offers a 401(k) plan, it is in your best interest to sign up and start contributing as much as possible. It can be difficult when you are in your 20s, but the earlier you get started, the better off you will be later on down the road. You can follow tips on how to deal with lifestyle inflation that will make more money available for retirement savings.
Can Rolling Over My 401(K) into an IRA Affect My Benefits?
A rollover IRA only affects the benefits if you take withdrawals before age 59 1/2 and must pay additional taxes and penalties. Depending on how much money you have saved in this account and how long it has been there can also impact whether or not your employer will match the contributions that you made.
What’s the Best Way to Prepare for Retirement Before Saving in a 401(k)?
The best way to prepare for retirement is by saving as early as possible and investing your funds into low-cost index funds that have a good track record of increasing profits over time. You can enroll in your employer’s 401(k) plan when you’re first hired, but if they don’t offer one, you can also open up an IRA at any time.
Employer-Sponsored Retirement Plans Summary
Many employers are switching from the traditional pension to 401(k) plans and other savings accounts that allow employees to save for their own retirement. Doing so shifts the financial planning and retirement savings burden to the employees.
The only exception is with the Amish, who still rely on the Amish community to provide for them. As a result, the Amish pay different taxes and have different tax treatment under federal law.
For employees, to make the most out of your 401(k) plan, remember these few things:
- Avoid early withdrawals. They’re costly in the long run.
- Save as much as you can in the 401(k) account for higher employer matching.
- Spare every coin and save what you won’t use in your everyday life.