What Is a 401(k)? Pros and Cons
A 401(k) is an employer-sponsored retirement plan – so-named after a part of the U.S. tax code – offered by companies to the employees who work there. Similar plans for teachers, nonprofit employees and government workers include 403(b)s and 457s.
Although 401(k)s are offered through an employer, each company’s plan is technically managed by a plan administrator (e.g., Vanguard, Fidelity, etc.) — a licensed and insured brokerage that provides access to investment options. When a company chooses a 401(k) administrator, the fact that the plan represents a pool of investors means it may be able to negotiate access to lower-cost investments — cheaper than you’d be able to find on your own as an individual investor.
Within the 401(k) plan, you have an individual account where you decide how much to contribute and how to invest your savings.
401(k) plans have three awesome features that help turbocharge your retirement savings:
- It’s a totally legal tax dodge on a substantial chunk of your money: Money in a 401(k) is off limits from the IRS. Investment growth? Back away, Uncle Sam. Dividends? Denied. As long as the money remains in the account’s protective cocoon — a time span that could last decades — you pay nothing on your gains. If that doesn’t set your heart aflutter, then how about yet another tax break?
- You get either an upfront tax break or tax-free withdrawals in retirement: If your company offers both a traditional 401(k) and a Roth 401(k), you get to choose a second tax break. In a nutshell, every dollar you contribute to a traditional 401(k) lowers your taxable income for the year. (That’s why they call it “pre-tax” contributions.) In a Roth 401(k), you don’t get a tax break on contributions … but you pay no taxes (zero! zilch!) on withdrawals from the account in retirement. (If your employer offers only a traditional 401(k), then you don’t have a choice here, but you still get access to a powerful tool for reducing your taxable income for the year.)
- Access to company-supplemented retirement savings: Many employers provide workers with financial help saving for retirement by contributing money to employee accounts. Known as a “company match,” “employer match,” or, more colloquially, “free money,” this feature means your boss matches whatever contributions you make up to a certain percentage of your salary.
Example: If you make $75,000 a year and contribute 10% of your salary ($7,500), an employer offering a 4% match brings your annual 401(k) balance to $10,500. That’s a 40% return on money in the first year, even before taking into account investment gains. (Some particularly benevolent employers kick in money even if you don’t contribute.) The company match is the reason we recommend that, if you have access to a 401(k) with a match, you start your retirement savings journey with that account. It’s like hitting an investing home run on your first at-bat. (If your company doesn’t offer a match, see IRA vs. 401(k): How to Choose for your game plan.)
How 401(k)s work
Because 401(k) plans are offered through an employer, a lot of the administrative hassle of setting up and managing the account is taken care of for you. But you do have to make a few key decisions along the way. Here’s what’s involved:
Set up your account through your employer. Somewhere in that stack of paperwork (or PDFs or link to your employee benefits portal) your HR person handed you during your first week on the job are instructions on signing up for the company 401(k). You’ll be asked to indicate how much you want to contribute as either a percentage of your salary or a dollar amount. Your company’s payroll department takes care of the rest. Money is automatically taken out of your paycheck each pay period and deposited into your investment account. You can check on your savings and use any tools offered on your plan administrator’s website at any time.
Decide which type of 401(k) account you want to use. Here we’re talking about traditional 401(k) vs. Roth 401(k), the difference being how contributions and withdrawals are taxed (or not taxed). (See more below under “Types of 401(k)s.”) Not all companies offer the Roth 401(k) option, which means a traditional 401(k) may be your only choice. But if you have access to both, know this: You can choose one, the other, or split your 401(k) contribution (50-50, 70-30, or however you want) between the two as long as your total combined contribution does not exceed the IRS’s maximum allowable amount.
Decide how much money you want to contribute. Unlike traditional pension plans that are funded primarily by the company, 401(k)s are funded by the workers (though if your company has a match, they’re helping too). The IRS caps how much individuals are allowed to save in a 401(k) each year. For 2023, you can save up to $22,500 ($30,000 if you’re 50 or older). Any company match is not included in this amount. Some companies automatically enroll employees in the company 401(k) at a low percentage of salary (such as 3%) and incrementally increase contributions over time. Don’t assume you’re automatically enrolled once you start a new job. Look at your plan rules, and, if need be, adjust your contribution amount.
investor.com Quick Tip: How much should you contribute to your 401(k)?
There is no minimum you’re required to save in a 401(k), but at the very least, aim to contribute whatever it takes to receive the full company match (aka free money). If your financial circumstances change — you’re feeling flush after getting a bonus or need to tighten your belt to cover present-day expenses — you can adjust the amount you contribute throughout the year.
Choose your investments. Getting money into a 401(k) is step one. Step two is getting that money invested so it grows to a handsome sum for your retirement, otherwise it may sit in cash and lose buying power to inflation. On your 401(k) website is a list of investment options offered to all plan participants. The average 401(k) plan offers 21 mutual funds, according to Plan Sponsor Council of America. That may sound like a lot, but the array is designed so that the majority of participants can find options that suit their time horizon and risk tolerance.
Once you indicate how you want your contributions invested, every subsequent deposit made into your 401(k) is automatically allocated proportionally into your choice(s). At any time you are free to change your investment choices within the options offered in your plan.
investor.com Quick Tip: One 401(k) investment that does it all
Overwhelmed by your investment choices? A simple option that’s a staple in many 401(k) plans is a target-date mutual fund. A target-date fund contains a mix of investments based on the investor’s planned retirement year. As time passes, the investment mix shifts to dial down exposure to risk. Target-date funds are intended as a one-stop shop: You choose one mutual fund based on your retirement year, and that fund does the rest.
Take it (or leave it) when you leave your job. Any money you invest in your 401(k) is yours to keep, in addition to any vested matching contributions your employer made, even after you leave the company for greener pastures. At that point you can roll the money into an IRA at a brokerage of your choice, where your money can continue to be shielded from taxes until you start taking withdrawals in retirement, plus you’ll have access to a larger choice of investments and more control over fees. (See more in What is an IRA?)
You may also be allowed to leave your money in the 401(k), but be aware that as an ex-employee, you will no longer get any company match, and you may be asked to pick up the tab for plan administration fees. (See IRA vs. 401(k) for more on the pros and cons of each option.)
Types of 401(k)s
There are two main types of 401(k) plans: the traditional 401(k) and the Roth 401(k). Both offer tax breaks on the money you contribute from your salary into the account, and both shield investment growth within the plan from taxes. The difference between a traditional and Roth 401(k) is how and when the IRS collects taxes.
Because, sorry to be the bearer of bad news, you can’t hide from the IRS forever.
What is a traditional 401(k)?
A traditional 401(k) plan provides a break on income taxes for the year you make the contribution. Here’s how: Every dollar you contribute to a traditional 401(k) reduces your taxable income on a dollar-for-dollar basis. For example, if you make $75,000 a year and contribute $10,000 to your 401(k), your taxable income will drop to $65,000.
Investments within a traditional 401(k) grow on a tax-deferred basis. But eventually the IRS wants to be paid for all the taxes you avoided paying on contributions. (Brace yourself for the inevitable other shoe to drop.) That happens when you start making withdrawals in retirement. At that time you will owe income taxes on those distributions at whatever income tax rate you’re in.
The upfront tax break is what makes a traditional 401(k) a good choice for those in their prime earning years or those who expect their income to be lower in retirement. It allows you to take your tax break when you need it most, and defer the taxes owed to future years when you’re in a lower tax bracket.
What is a Roth 401(k)?
Roth 401(k)s are a newer entrant into the field of employer-sponsored retirement plans. As such, not all companies offer the Roth option in their 401(k) plans.
There is no upfront tax break on contributions to a Roth 401(k) like there is with the traditional 401(k). So, if you make $75,000 a year and contribute $10,000 to your Roth 401(k), you’ll still start off that tax year’s return showing $75,000 in taxable income. Shed no tears, because the consolation prize is pretty sweet.
Unlike traditional 401(k)s, investments within a Roth 401(k) grow on a tax-free basis. Because you already paid income taxes on the money you contributed to the account, when you make withdrawals in retirement, you will owe nothing in taxes.
Tax-free withdrawals in retirement are what make a Roth 401(k) a good choice for young savers or those early in their careers. It allows you to take care of taxes now, while you’re in a relatively low tax bracket, and provides relief in the future when you’d be subject to a bigger income tax hit.
There are some rules that apply to all 401(k) plans, regardless of where you work or what plan administrator your company uses. For example, the IRS dictates contribution limits and how contributions and withdrawals are taxed.
The differences in 401(k) rules come down to which plan features your company chooses to offer. Those include whether there’s a company match (how much it is, whether there’s a vesting schedule), what and how many investments are available, whether to offer a Roth 401(k) option, who pays the plan’s administrative fees, and whether to allow participant loans.
|2023 contribution limits||$22,500 ($30,000 if you’re 50 or older)|
|How contributions are taxed||Traditional 401(k): Contributions lower your taxable income for the year on a dollar-for-dollar basis
Roth 401(k): Contributions are included as part of your taxable income
|How investment growth is taxed||Investment gains are untaxed while the money is in the account|
|How withdrawals are taxed||Traditional 401(k): Distributions taxed as ordinary income
Roth 401(k): Distributions are not taxed
|Roth option available||At employer’s discretion|
|Accessibility||Available only to employees of a company that offers a plan|
|Funded by||You; and employer if company offers matching contributions|
|Investment choices||Options selected by the plan administrator (primarily mutual funds)|
|Fees||Administrative fees may be passed on to participants or covered by employer|
|Requires minimum withdrawals starting at age 72||Yes, unless you are still working at the company|
|Allows qualified withdrawals before age 59½ (income taxes and a 10% early withdrawal penalty may apply)||Some 401(k) plans allow withdrawals for hardships (e.g., medical, funeral, tuition/education, first-time home purchase expenses), but you may still owe a 10% early withdrawal penalty
Allows early access to 55+ retirees
|Loans from the account are allowed||Yes, if company plan rules allow it|
Now that you’re familiar with how 401(k)s work, the difference between traditional and Roth 401(k)s, and the rules that govern these plans, let’s get into the pros and cons to help you suss out the best — and worst — of your retirement plan.
The biggest item to celebrate in the “pro 401(k)” column is when an employer offers to contribute money to employee accounts. But even if your 401(k) plan has no “matching” component, the account still provides savers a lot of cover for a large portion of your retirement savings to grow free from the IRS’s reach. That’s on top of the tax breaks you get on either contributions or withdrawals. Here’s what else is particularly great about the 401(k):
- High contribution limits. The IRS allows savers to contribute up to $22,500 a year ($30,000 if you’re 50 or older) in a 401(k) in 2023. That’s a lot of money you can shield from taxation, and a big upfront or future tax break, depending on the account type you choose. That’s why, for most people, 401(k) savings represents the bulk of their retirement portfolio.
- Free money! (If your employer offers it.) A company match — where your employer matches a percentage of the contributions you make to your account — is the prime perk of 401(k)s. In 2021 nearly half of the defined-contribution plans run by Vanguard offered this perk to participants.
- Access to a Roth account (maybe). At year-end 2021, 77% of employer-sponsored plans managed by Vanguard had adopted a Roth feature. If yours is one of them, that means you get to choose when you want your tax break. Access to a Roth 401(k) is especially beneficial for those who otherwise do not qualify to contribute to a Roth IRA, since income restrictions do not apply to Roth 401(k) eligibility.
- Possibility of lower investment fees. Because 401(k)s represent a big chunk of business for plan administrators, your company may be able to negotiate the equivalent of a bulk discount on certain investments. The discount comes in the form of a break on mutual fund management fees. Larger plans often have access to lower-fee versions of mutual funds than individual investors can get in an IRA. Although the difference may be just a fraction of a percentage point, the savings can add up over time, leaving more money in your account to compound.
- The ability to take out a loan against your balance. Some 401(k) plans allow participants to borrow against the money saved in your 401(k) account and pay it back to yourself — typically required within five years — with interest over time. This feature can come in handy in the event of a big unforeseen cost. Each company decides whether to offer this option within the 401(k) plan, and the circumstances under which it’s allowed can vary from plan to plan. (See the IRS’s Do’s and Don’ts of Hardship Distributions.)
- A penalty-free head start on retirement withdrawals. Those within spitting distance of retirement age, take note of the Rule of 55. If you’re retiring from the workforce entirely — and not just leaving your job for a new gig — the IRS lets you take penalty-free distributions from your 401(k) starting at age 55 instead of waiting until age 59½. You’ll still owe taxes (unless you’re tapping into a Roth 401(k)), but the Rule of 55 gets you out of having to pay the 10% early bird penalty.
- Protection from creditors. Employer-sponsored retirement plans offer some of the best protections against creditors if you are sued or declare bankruptcy. This creditor protection comes under the Employee Retirement Income Security Act (ERISA), under which 401(k) plans fall. The exception is in instances of paying family support or dividing property after a divorce where a state court can determine how much of a participant’s retirement benefit is paid out.
Companies get to set a lot of their own rules in 401(k) plans. You might be surprised how different two 401(k) plans can be, even if both of them are managed at the same investment firm. For that reason it pays to be familiar with your specific company’s 401(k) to be aware of any shortcomings in terms of eligibility, investment offerings and fees.
- Waiting periods. The best time to start saving for retirement is with your very first paycheck. That might not be allowed if a company plan has a waiting period — which can be anywhere from a few months up to one year — before new employees are eligible to start making contributions. Just make sure to get your plan paperwork in ASAP so you’re ready to take off once you get the all-clear.
- Not all employees may be eligible to contribute. Some 401(k)s limit access to full-time employees only. Companies can adopt more lenient eligibility requirements if they choose. Roughly three-quarters of the 500-plus 401(k) plans surveyed by the Plan Sponsor Council of America allowed salaried part-time employees to contribute, and almost 70% let hourly part-timers participate in a plan.
- There may be no company match. Companies are not legally required to offer an employer match program in their 401(k) plans. (It pays to find out the plan policies when comparing job offers.) Also know that in times of corporate belt-tightening, this perk is often one of the first things to go.
- Company contributions may not be yours right away. Job hoppers beware. Although all of the money you contribute to a 401(k) plan is yours, free and clear, when you leave your job, matching contributions made by the company can be subject to a vesting schedule (e.g., one to six years). Quit before that money vests and you’ll have to leave it behind.
- Not all plans offer a Roth 401(k) option. Although more companies have added a Roth 401(k) option to their retirement plan offerings, many don’t — especially smaller employers. That leaves you with one choice: The traditional 401(k), which works like a traditional IRA. This forces savers who want the benefits of a Roth account to use a Roth IRA, if they meet contribution requirements.
- Limited investment choices. Investment options within 401(k) plans are limited to whatever your provider chooses to offer. The average 401(k) plan offers 21 mutual funds, according to Plan Sponsor Council of America. Although plans try hard to offer mutual funds to serve all types of investors, there can be holes. For example, socially responsible mutual funds or country-/industry-specific funds may be limited or nonexistent in your 401(k).
- Investment fees are out of your control. Limited investment choices mean limited opportunities to comparison shop for lower-fee options. If your plan offers just one S&P 500 Index mutual fund, that’s it. Dig deeper and you might notice that the index fund your plan offers has a higher expense ratio (the amount a fund company subtracts from your investment to cover management costs) than the S&P 500 Index mutual fund in another company’s plan.
- Participants may have to pay plan fees. Running a 401(k) plan costs money, with administrative fees ranging from less than 1% to more than 2%, depending on the number of participants and amount in assets. One study found that the average person pays $248 a year in 401(k) fees, including administrative, investment and service fees. That’s $248 of your hard-earned money that’s skimmed off of the top of your savings. Some employers cover the cost of plan management (administrative) fees. Others pass them along to participants, automatically deducting a proportionate amount from your savings. (Your 401(k)’s summary plan description and annual report documents spell out your plan’s expenses and fees and how they are distributed.)
- Some perks disappear after you leave the company. After you give notice, your access to things like the company matching contributions and ability to take a loan gets cut off. You may also have to start paying any 401(k) administrative fees that the company covered while you were an employee. As noted above, the money you contributed plus any vested matching contributions are yours, free and clear. Depending on your account balance and other plan rules, you may be required to take your money with you. In that case, you can directly roll over the money into an IRA with the same tax treatment (e.g., Roth 401(k) to a Roth IRA, or traditional 401(k) to a traditional IRA). That’s not necessarily a bad thing. Moving your money to an IRA, which is only allowed after you leave the company, gives you access to a broader range of investments and more control over fees. (See more on the pros and cons of IRAs.)
- You’re required to start withdrawing money at age 72. Unless you are still working at the company, you’ll have to start taking required minimum distributions from your 401(k) at age 72, whether you need the income or not. This applies to both traditional and Roth 401(k) plans. (Roth IRAs don’t require RMDs.) If you don’t withdraw the amount the IRS requires, you’ll pay a heavy 50% tax on the amount, on top of any income taxes you owe. Say goodbye to the tax-sheltered investment growth you’ve enjoyed.
Is your employer required to contribute to your 401(k) with a company match?Show me!
The bottom line on 401(k)s
Despite the potential drawbacks (fees, limited investment choices), 401(k)s are a great retirement savings tool. As noted above, it behooves you to save at least enough to get any company match that’s offered. Otherwise you’re leaving free money on the table. Even if your company doesn’t supplement your savings, the high contribution limits offer a roomy parking spot for tax-advantaged savings.
A 401(k) is not your only savings option, however. You’re also allowed to save money in an IRA at the same time. We pit these two retirement savings stalwarts against each other in our IRA vs. 401(k) explainer, and map out a game plan on how to choose if you have limited retirement investment dollars at your disposal.