401(k) plans have been around for decades, and millions of Americans have successfully used them to help with saving for retirement. Named for the section of the tax code that enables them, a 401(k) is an employer-sponsored plan that allows you to withdraw funds directly from your paycheck to save for retirement. Having the money come out directly from your paycheck makes it quite easy to save for retirement.
There are several benefits that come from contributing to a 401(k) plan. You’ll get a tax break for contributing to your account, since contributions made to a traditional 401(k) are made with pre-tax dollars, reducing the gross income you’ll need to report to the IRS that year. Many employers also make matching contributions to their employees’ 401(k) accounts. Still, with so many other ways to save for retirement available now, you might be wondering if 401(k)s are worth it.
Key Points
• A 401(k) is an employer-sponsored retirement plan allowing tax-advantaged contributions that can be invested and withdrawn in later years.
• Traditional 401(k)s allow employees to make pre-tax contributions, meaning they reduce taxable income for that year, while Roth 401(k)s allow employees to make after-tax contributions.
• Employer-matching in 401(k)s can provide additional funds, enhancing retirement savings.
• 401(k)s have higher contribution limits than IRAs but are limited by employer investment options.
• In comparison with savings accounts, 401(k)s offer higher potential returns but come with penalties for early withdrawal.
How 401(k) Plans Work
A 401(k) is an employer-sponsored plan, which means that you have to be employed by a company that offers one. If your employer does not offer a 401(k) program, in most cases, you can not start one on your own. In that case, you may need to look for other options, and may want to think about opening an IRA.
If you do have a 401(k), you can specify a percentage of your total pay or an amount to be withheld from your paycheck each pay period. Contributions to a traditional 401(k) account are made with pre-tax dollars and are therefore not counted in the gross income you’ll need to report to the IRS (likely lowering your overall tax bill). Instead, you will pay income tax based on the amount of money you withdraw from your account when you reach retirement age. You can also choose how to invest your contributions, based on a list of investment options provided by your employer.
401(k) Matching Explained
Many employers offer 401(k) matching as an additional employee benefit, and employers can set up matching programs in a variety of different ways.
One example might be that a company might offer to match 50% of your contributions, up to a maximum of 6% of your pay. So if you contribute the full 6% of each paycheck to your 401(k) account, your employer will contribute an additional 3%.
Effectively, employer matching allows employees to benefit from “free money” coming from their employer directly into their retirement plans.
Pros and Cons of 401(k)s
401(k)s, like any other investment and savings vehicle, have advantages and disadvantages. Here are some pros and cons of 401(k) accounts.
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Pros:
• 401(k) plans are tax-advantaged, allowing for pre-tax (traditional) or post-tax (Roth) contributions
• The contribution limits are higher than that of other retirement options (like IRAs)
• Your employer may offer matching funds
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Cons:
• Investment options are limited to what is offered by your employer
• There is a limit to how much you can contribute each year
• Some investment options may come with fees
401(k) vs Savings Account
If you’re considering where to put your money and deciding between 401(k) retirement savings versus stashing it in a regular savings account, there are a few things to keep in mind.
Money you put into a traditional 401(k) account is intended for retirement, so you may face penalties and an additional tax bill if you take it out before you reach retirement age. However, the investment options available in many 401(k) accounts may allow you to earn higher returns than those available in savings accounts. The money in a savings account would only accrue interest.
Here’s a hypothetical look at how returns may generate at various rates. All figures are for $50,000 invested in a diversified (401)k, assuming a 401(k) was invested entirely in an S&P 500 index fund, and at varying rates of return (compounding continuously, meaning that an investor earns returns on their initial investment, plus their returns, repeatedly) with no additional contributions.
Additionally, in the chart below, the percentage of corresponding rates of return is based on an inflation-adjusted return, and this percentage can be even lower based on time in the market. We’ve also included the rate of return for a hypothetical savings account, which might pay out 0.4% annual interest, for comparison:
| Starting amount | Rate of Return | Ending amount after 20 years |
|---|---|---|
| $50,000 | 0.4% | $54,156 |
| $50,000 | 3% | $90,306 |
| $50,000 | 5% | $132,665 |
| $50,000 | 7% | $193,484 |
| $50,000 | 10% | $336,375 |
As you can see, even a small increase in your overall rate of return may pay dividends in the long term. There can also be a place in your overall financial plan for both retirement savings and regular savings accounts, but generally, it’s probably a good idea to make sure that any money you are investing for the long term has the highest possible rate of return, given your risk tolerance. Typically, the higher the potential rate of return is for an investment, the higher the potential risk involved.
Compound Interest vs Simple Interest
Depending on how you are investing or saving your money, you may earn interest. And that interest may be calculated as simple interest, or compounded on a particular schedule.
Many investments in the stock market that you might use in a 401(k) account may compound continuously. Other investments like bonds, CDs, or savings accounts may use simple interest or compound interest on other schedules.
Here’s a look at how a $50,000 investment would grow at a 7% interest rate, using either simple interest or interest compounded at various other timeframes:
| Starting amount | APY | Ending amount after 20 years |
|---|---|---|
| $50,000 | 7%, simple interest | $120,000 |
| $50,000 | 7%, compounded annually | $193,484 |
| $50,000 | 7%, compounded quarterly | $200,320 |
| $50,000 | 7%, compounded monthly | $201,936.94 |
| $50,000 | 7%, compounded continuously | $202,760.00 |
401(k)s vs IRAs
401(k)s and Individual Retirement Accounts (IRAs) are both types of accounts that may give you tax advantages for saving for retirement. Again, a 401(k) is a retirement account sponsored by your employer, while an IRA is something you set up individually.
There are pros and cons with an IRA vs 401(k), so make sure you understand how they both work. That way you can make the best decision for your unique situation.
Perhaps the most stark difference between the two is the amount you can contribute in a year. For 2024, contribution limits are $23,000 in a 401(k) versus $7,000 in an IRA.
Is a 401(k) Right for You?
There are many different types of retirement accounts, and a 401(k) account can be an important part of your retirement plan. Check with your employer to see if they offer a 401(k) account, what investment options are available, and whether they offer any matching funds. Then consider how that fits in with your other retirement options to decide if a 401(k) is right for you.
The Takeaway
401(k) accounts are employer-sponsored retirement accounts that may be available as an employee benefit. When you contribute to a traditional 401(k) plan, the amount you contribute is not counted in the total gross income you’ll need to report that year. This may allow you to lower your overall tax liability. Additionally, many employers offer a 401(k) matching program, where they provide additional funds into your account as an employee benefit.
It can be a smart financial decision to use one of these accounts to make sure you have enough money put aside for your retirement.
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FAQ
Is a 401(k) worth it anymore?
There are many different kinds of retirement plans, and each come with their own pros and cons. A 401(k) is a valuable tool that may be a good choice for many Americans. Compare the benefits of a 401(k) with the benefits that come with other types of retirement plans to make the best choice for your specific situation.
Is it better to have a 401(k), or just save money?
It can make sense to keep some of your money in safe investments like cash or money market accounts. Having a few months’ worth of expenses in cash or cash equivalents can serve as a useful emergency fund. However, you likely won’t want to keep too much of your money in these types of investments, since they generally offer lower returns than investments that might be available in a 401(k) account.
What are the main disadvantages of a 401(k)?
While a 401(k) account has a lot of benefits and advantages, there are a few disadvantages. First is that you can only open a 401(k) account if your employer offers one, and your employer controls what investments are available. You also are limited in how much money you can contribute to a 401(k) account each year.
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