Is a 401(k) a Good Investment?

Ravi Kurani
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It’s important to invest in your financial future. But is a 401(k) plan a good vehicle for that goal? Let’s explore that in this post.

According to data from Bankrate, more than half of Americans feel they aren’t saving enough for retirement. It’s easy to understand why this is the case, especially given the economic turmoil of the last two years.

But consider this: the median household income in the U.S. for 2021 was $79,900. If you invest 15% of that every year for 35 years, you’ll come out with $1.1 million.

So not investing in retirement means that you’re leaving money on the table—in the form of potential growth.

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As a result, investing in retirement should be a significant part of your approach to financial freedom.

But there are many vehicles to build wealth:

  • Traditional 401(k) retirement plans
  • Roth 401(k) retirement plans (after-tax)
  • Individual retirement accounts (IRA, both traditional and Roth)
  • Brokerage account
  • Collecting money under your mattress (please consult with your financial advisor and mattress company before doing that)

Given all of these options, it’s prudent to ask: is a 401(k) a good investment?

Let’s dive into the pros and cons to find out.

What is a 401(k) plan?

A 401(k) plan is a tax-deferred account: meaning that you invest your pre-tax dollars into a number of limited investment options. Usually, this happens every pay period. That money continues to grow over time, and when you reach age 59½, you can withdraw the funds and pay taxes on them.

One of the biggest advantages of investing in a 401(k) is the employer match. Typically, an employer will match a part or all of every dollar you put in, up to around 3-6% of your income.

The pros of a 401(k)

Tax savings

If your post-retirement tax burden will be lower than during your working years, deferring taxes can be a massive benefit to you. Additionally, your contribution is deductible, lowering your taxable income for the year. Around 30% of an annual $2,000 contribution is canceled out just from those tax savings.

Employer match

As we mentioned above, your employer match is a major benefit of a 401(k). You should think of this money as part of your compensation plan, and make sure you’re not leaving any of it on the table.

401(k) loan

As you build up your 401(k), you’re building up an asset. This gives you something to borrow against in the event of an emergency. In some cases, this is a better option than withdrawing the money, as you’ll pay a 10% penalty for the withdrawal. However, there are some requirements regarding paying back the loan—if you leave the company, for instance, you have to pay back the entirety of the loan within 30 days.

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The cons of a 401(k)

Investing limitations

One of the biggest drawbacks of a 401(k) is that you can only contribute $20,500 of your income every year (as of 2022). This amount goes up to $27,000 for people over the age of 50. Younger people with smaller incomes may not find these limits challenging, but it can become a problem as you get older and want to more aggressively save for retirement.

High 401(k) fees

Another downside to a 401(k) are the high fees. Most of these are hidden in the fine print of your agreement, so you’ll want to talk to your HR department or plan sponsor to uncover these details. It may also be worthwhile to compare the fees to the match: if your employer offers a high match, it’s possible that match will outweigh the costs of the account.

Limited investment opportunities

When you invest on your own, the sky’s the limit. When you invest in a 401(k) plan, there are some significant limitations as to where that money goes. Make sure you take the time to compare all the investment options available in your plan and find the balance that suits your financial goals and objectives.

Penalties for early withdrawal

If you’re below the age of 59½, then you can’t withdraw funds from your 401(k) without incurring a 10% penalty, in addition to the typical income taxes on that fund. This can present problems, especially if you need to take money out of that account to cover an emergency.

However, there are some exceptions to the 401(k) early withdrawal penalty:

  • Hardship distributions to cover medical bills, home down payment, funeral expenses, and education costs (your plan will define what qualifies as a “hardship”)
  • Substantially equal periodic payments, where you take the same amount of money out for at least five years, or until you hit age 59½ (whichever comes last)
  • You leave your job at age 55 or older
  • Death
  • Disability
  • Division of assets in a divorce
  • Rollover to another 401(k) or IRA
  • Birth or adoption of a child (up to $5,000 per account)
  • Payment of an IRS levy
  • Victim of disaster
  • Over-contribution or auto-enrollment in a 401(k) program (within certain time limits)
  • Military reservist call to active duty

401(k) investing alternatives

Although investing in a 401(k) to claim your employer match should be part of your retirement plan, it’s not the only place you should be investing. Let’s look at some of the other options that can balance out the cons of a 401(k) plan.

Individual retirement accounts (IRA)

Perhaps the most common compliment to a traditional 401(k) is an IRA. IRAs function very similarly to 401(k), without many of the limitations that employer plans have.

There are two types of IRAs: traditional and Roth. Traditional IRAs are pre-tax investments, while Roth IRAs are after-tax. The advantage of the Roth is that you pay taxes on the money now, then allow it to grow tax-free. However, there is a $6,000 annual limit for how much you can put into a Roth IRA.

Additionally, IRAs provide you with a much wider range of options than a typical 401(k) plan. After you claim your employer match, it’s worth it to consider putting the rest of your retirement investments into one of these types of accounts.

Taxable investments

While stashing away money until retirement is a good idea, there are advantages to having that money more easily accessible. As a result, you may want to consider investing in assets that don’t have any time or age restrictions on liquidation:

  • Mutual funds
  • Index funds
  • Individual stocks
  • Real estate
  • Commodities
  • Cryptocurrency
  • NFTs

Not all of these investments are created equal. It’s important to consider the volatility, your own risk tolerance, and your short- and long-term goals when building your investment portfolio.

Should you invest in a 401(k)?

While a 401(k) is far from a perfect investment vehicle, its advantages are certainly worth taking it seriously. Most important is the employer match, which alone makes it worth it—after all, you don’t want to leave money on the table.

Beyond your employer match, it’s important to find a trusted financial advisor who can help you figure out which approach to retirement is best for you.

But above all else: make sure you’re putting something toward your retirement. Your future self will thank you for it.

To get started and claim your employer match, use the calculator below to see if you qualify for support from Matchly.

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