The 401(k) plan is a common retirement saving plan many employers offer. This retirement plan is preferable by many employees due to its tax benefits and higher contribution limits. The benefits of the 401(K) plan are so great that many people apply to jobs solely based on the 401(K) benefits and similar retirement savings packages they will be getting. While the 401(k) plan sounds promising, it is critical to know the benefits of 401(k) plans and their disadvantages to make informed decisions.
In this article, I will walk you through the 401(k) benefits and drawbacks you should know.
Without further ado, let’s get started.
1. Deductible contributions
If you are like me, you were probably skeptical when you first opened a 401(k) plan. It took me a while to know all the tax benefits of a 401(k) plan and why it was essential to my financial planning strategies. Tax savings is probably one of the biggest 401(k) benefits that makes it stand out which was also the main reason I started making optimal contributions to the plan.
With a pre-tax 401(K) plan, your contributions come from your before-tax money which in turn lowers your taxable income every year you make contributions.
2. The 401(k) plan has higher contribution limits
Another big benefit of 401(K) is that it comes with larger contribution limits compared with other retirement accounts. In 2024, you can contribute up to $23,000 or $30,500 if you are 50 or older. For 2023, the contribution limits for your 401(k) plans are $22,500 or $30,000 if you are 50 or older.
These contribution limits are higher than IRA limits which are $7,000 in 2024 and $8,000 if you are 50 or older. For 2023, the IRA contribution limits are $6,500 or $7,500 if you are 50 or older.
Having a large contribution limit helps you grow your account much faster. Since you will most likely invest the money in your 401(K) account, higher contributions boost your account growth through ROI and compound interest.
Read more: What are the 401(K) contribution limits in 2024?
3. Employer match
An employer match is a percentage of money your company contributes to your 401(K) for every contribution you make. The matching contributions can be as little as 0% to 100%. Most companies match employees’ contributions by 3% or 6%. Any contribution your employer makes to your 401(k) plan is free money to your account.
Keep in mind that your employer might have a vesting process where you are required to work within the company for a given number of years before the match becomes yours 100%.
4. 401(K) plans help companies attract and retain talented employees
What makes 401(k) plans exceptionally good is that they benefit employees and employers at the same time. Employers with 401(k) plans usually have a higher employee retention rate than those who don’t. Many companies use 401(K) plans to attract and retain highly talented employees as many people settle for high-paying jobs with great benefits.
The 401(k) plan is so important to businesses that many businesses use their 401(K) benefits as a talent acquisition strategy. Yes, companies know that by giving you great benefits, you will more likely stay longer.
That is why some big companies in competitive markets match your contributions 100%. Anything you put down, they double it. As a person who is benefiting from higher matching contributions, you get to grow your account much faster with free money.
Related: 16 best employee retention strategies that work for 2022
5. You can take a loan from your 401(K) plan
Did you know that you can borrow against your 401(k) plan and pay it back just like any other loan? That is right. Many 401(k) plan offers loan options which is one of the best features of 401(k) plans that make them stand out.
How does borrowing against your 401(k) plan work?
The rules for borrowing money from your 401(K) vary from one employer to another. Some companies allow you to borrow up to 50% of your total account value and up to a maximum of $50,000, according to Fidelity. In addition, there is a limit to how many 401(K) loans you can take in a year. The rules vary from one plan to another. To know exactly what you need to do to borrow against your 401(k) plan, contact your employer.
The money you borrow must be paid back together with interest. 401(k) loans benefit employees because you borrow against your account and the money is paid back into the same account. In other words, you borrow against your own money and pay interest to nobody other than yourself.
The benefits of 401(k) loans are that the loans prevent you from withdrawing money early which can trigger a penalty and tax liabilities. Additionally, borrowing against your 401(k) plan gives you access to capital without taking out expensive loans from private lenders.
The 401(K) loans must be paid within 5 years and defaulting on these loans could result in taxes on the money you borrowed plus a 10% penalty if you are under 59 1/2 years old.
6. Safety of your money
Contributions you make to your 401(K) plan are well-managed and carefully invested. The investments you make in your account are specifically designed to protect your retirement savings and maximize your returns at the same time.
A typical 401(k) plan is also managed by your plan provider which helps you grow your funds without doing all the work. All you have to do is make contributions to the plan and relax.
7. Automatic savings
Saving for retirement is challenging for many people. Let alone saving for retirement, people cannot even save for their house down payments. That is why automation of your retirement savings is one of the benefits of 401(k) plans that make your experience seamless.
Every dollar you contribute to your 401(k) plan comes from your before-tax wages through payroll deductions. You don’t get to see or touch the part of your wages that goes to your 401(K) account. That amount goes to the account automatically from your employer.
The only thing you do to your 401(K) account is to decide the percentage of your wages you want to allocate for retirement. After setting up this percentage, the money will go to the account directly and get invested right away. You can also decide on investment options inside your plan or let it be managed by the plan provider.
Disadvantages of 401(k) plans
While there are a lot of 401(k) benefits, the plan also comes with drawbacks you should know. The following are 401(k) drawbacks to keep in mind.
1. Limited access to your funds
You generally cannot withdraw funds from a 401(k) until you reach the age of 59.5 years without paying a penalty.
2. There is a 10% penalty for early withdrawals
If you do need to withdraw funds before the age of 59.5 years, you will likely have to pay a 10% penalty. In addition to this penalty, you will pay an income tax on the amount withdrawn.
3. Limited investment options
401k plans often have a limited number of investment options compared to other types of investment accounts such as IRAs. With a 401(k) plan, you can only invest in what is provided inside the plan which can limit your earnings potential.
4. 401(k) plans come with higher fees
Some 401(k) plans have high fees that can eat into your investment returns especially if you invest in actively managed funds.
5. Required Minimum Distributions(RMDs)
Once you reach the age of 73, you must start taking withdrawals from your 401(k), whether you need the money or not. If not managed effectively, this could potentially push you into a higher tax bracket. Failure to take RMDs will result in a 50% excess tax on the amount you were supposed to withdraw.
How much will a 401(k) reduce my taxes?
The amount of tax contributions to your 401(k) plan reduces your taxes will depend on the following two main factors.
- Your contribution limits. For 2024, you can contribute up to $23,000 and $30,500 if you are 50 and older. In 2023, the contribution limits to 401(k) plans are $22,500 or $30,000 if you are 50 or older.
- Your marginal tax rate. This is the amount of additional tax paid for every additional dollar earned as income. To calculate your average tax rate, divide your total tax paid by your total income.
I should also mention that contributions to a traditional 401k are pre-tax meaning they reduce your taxable income for the year. Let’s assume that you contributed the maximum amount of $22,500 in 2023 and your marginal tax rate is 24%. To calculate how much your 401(k) plan will reduce your taxes, multiply your total contribution with your marginal tax rate.
Tax reduction = $22,500X24% = $5,400. Contributing $22,500 in 2023 will lower your taxes by $5,400.
The actual savings may be more or less depending on your specific tax situation, including your income, filing status, and other deductions or credits you may be eligible for.
