Understand the pros and cons of using a 401(k) when you have an employer or work for yourself so you have plenty of money when you’re ready to kick back and enjoy retirement.
Understand the pros and cons of using a 401(k) when you have an employer or work for yourself so you have plenty of money when you’re ready to kick back and enjoy retirement.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast
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A 401(k) retirement plan is one of the most powerful savings vehicles on the planet. If you’re fortunate enough to work for a company that offers one (or its sister for non-profits, called a 403(b)), it’s a valuable benefit that you should take advantage of.
You might be surprised to hear that when I got my first job with a 401(k), I didn’t enroll in it. I was nervous about having investments with an employer because I didn’t understand the rules, like how matching works and what happens if you leave the company or it goes out of business. Also, I mistakenly thought you had to be an investing expert to use a retirement plan.
I’ll review seven primary pros and cons of using a 401(k) when you have an employer or work for yourself. You’ll learn some lesser-known benefits and get tips to save more so you have plenty of money when you’re ready to kick back and enjoy retirement.
Hi, everyone, and thanks for joining me this week! I'm Laura Adams, a personal finance expert hosting the Money Girl Podcast since 2008, with over 42 million downloads.
I’m the founder of The Money Stack, a weekly newsletter helping you build your bank account and live rich on your terms. I also work with select brands doing on-camera and writing work as a financial spokesperson and female money speaker.
As always, you can reach me using my contact page at LauraDAdams.com. That's also where you can learn more about my newsletter, books, and money courses. Got a money question or idea for a show topic? Call 302-364-0308 and leave me a message.
What Is a 401(k) Retirement Plan?
A 401(k) is a popular retirement plan that can only be offered by an employer. If you’re self-employed with no full-time employees other than a spouse or business partner, you can have a similar account called a solo 401(k).
These accounts allow you to contribute a portion of your paycheck or self-employment income and choose various savings and investment options, such as CDs, mutual funds, and exchange-traded funds, to accelerate your account growth.
Traditional retirement accounts give you an immediate benefit by making contributions on a pre-tax basis, reducing your annual taxable income and tax liability. You defer paying income tax on contributions and account earnings until you take withdrawals in the future.
Or you might choose a Roth 401(k) if offered by your employer or investing firm. With a Roth, you must pay tax upfront on your contributions; however, your future withdrawals of contributions and earnings are entirely tax-free.
A Roth 401(k) or 403(b) is similar to a Roth IRA; however, unlike a Roth IRA, they don't have annual income limits to qualify for contributions. That means even high earners can participate in a Roth at work or have one for their own business and reap the benefits.
ALSO READ: 2024s big savings and retirement rule changes
Pros of Investing in a 401(k) Retirement Plan
A 401(k) retirement plan has many more advantages than disadvantages. Here are four pros for participating in one at work or your own business.
1. Having federal legal protection.
Qualified workplace retirement plans are protected by the Employee Retirement Income Security Act of 1974 (ERISA), a federal law. It sets minimum standards for employers that offer retirement plans and the administrators who manage them.
ERISA was enacted to protect your and your beneficiaries’ interests in workplace retirement plans. Here are some of the protections you get:
Keeping creditors out of your qualified workplace retirement plan is an important but lesser-known ERISA benefit.
Let’s say you have money in a 401(k), lose your job, and cannot repay your car loan. If the car lender gets a judgment against you, they can attempt to collect repayment from you in various ways, but not by tapping your workplace 401(k) or 403(b). There are exceptions when an ERISA plan is at risk, such as when you owe federal tax debts, criminal penalties, or an ex-spouse under a Qualified Domestic Relations Order.
Note that a solo 401(k) for the self-employed isn’t covered under ERISA because it’s not an employee benefit plan–but a plan for business owners and their spouses. So, a solo 401(k) doesn’t enjoy the same legal protections as a regular 401(k).
READ ALSO: What’s the difference between a 401(k) and solo 401(k)?
2. Getting employer matching funds.
Many employers that offer a retirement plan also pay matching contributions, which boost your 401(k) account value. They typically come with a vesting schedule, which means you must remain employed for a certain amount of time before you own some or all your employer-paid funds. However, you’re always 100% vested in the contributions that come from your paycheck.
For example, your company might match 100% of your contributions up to 3% of your income. If you earn $50,000 a year and contribute 3% or $1,500, your employer would also contribute $1,500 on your behalf. You’d have $3,000 in total contributions instead of $1,500. That would give you an instant 100% return on your contributions before any investment growth, which is fantastic!
Therefore, set your 401(k) contributions to at least maximize an employer’s match so you never leave easy money on the table!
3. Having a high annual contribution limit.
Once you contribute enough to maximize any 401(k) matching, set your sights higher by raising your savings rate annually. A good rule of thumb is to save at least 10% to 15% of your gross income for retirement and more when possible. For 2024, the allowable limit is $23,000, or $30,500 if you're over 50.
Most retirement plans have an automatic escalation feature that kicks up your contribution percentage at a pre-set time, such as January 1. For instance, you could set up your plan to increase your contributions by 1% every New Year until you reach 15% of income or max it out. That's a simple way to set yourself up for a happy and secure retirement.
If you have a solo 401(k), the annual contribution limits are much higher but depend on your business income. You can contribute up to the employee limit I just mentioned, plus an amount as your employer.
For 2024, a maximum solo 401(k) contribution breaks down to $23,000 or $30,500 as your own employee, plus a profit-sharing contribution of up to 25% of your business income, up to $69,000 or $76,500 if you're over 50. In other words, the more you earn, the more you can contribute to a solo 401(k).
Note that if you have a job with a 401(k) and business income, you can have both a regular and solo 401(k). However, the employee limits apply per person, not per plan. That means you can't exceed the employee limit of $23,000 or $30,500 if you're over 50 for 2024, no matter how many 401(k)s you have.
RELATED: How many retirement accounts can you have?
4. Getting free investing advice.
After you enroll in a regular or solo 401(k), you must choose from a menu of savings and investment options. Most plan providers, like Fidelity or Vanguard, have helpful resources like online assessments and free advisors. Take advantage of any customized advice for choosing the best investments for your financial goals and risk tolerance.
In general, the more time you have before spending a retirement account, or the higher your risk tolerance, the more stock funds you should own. Likewise, having less time or a low-risk tolerance means owning more conservative and stable investments, such as bonds, CDs, and money market funds, is better.
If you're unsure which investments to choose, don't hesitate to ask for help from your benefits administrator, retirement plan custodian, or financial advisor.
READ ALSO: 7 financial accounts you need for a richer life
Cons of Investing in a 401(k) Retirement Plan
While investing in a 401(k) retirement plan has terrific advantages, here are three cons to consider.
1. You may have limited investment options.
Compared to other types of retirement accounts, such as an IRA or a taxable brokerage account, your 401(k) or 403(b) may have fewer investment options. You won’t find alternative choices, like precious metals, commodities, or cryptocurrency, just basic asset classes, including stock, bond, and cash funds.
However, there are firms that allow you to invest in alternative assets or set up a self-directed retirement account. You can check out sites like Alto and BitIRA to learn more.
2. You may have higher account fees.
Due to the legal and accounting responsibilities required by employer-sponsored retirement plans, they charge fees to administer 401(k)s for employers. As a plan participant, you have little control over the fees you must pay.
However, if you have a solo 401(k), you can shop around and compare plan options, like the fees, investment choices, and the ability to make Roth contributions and take loans. Whether you have a regular or solo plan, one way to keep account fees as low as possible is by selecting low-cost index funds or exchange-traded funds (ETFs) when possible.
3. You must pay fees on early withdrawals.
One of the inherent disadvantages of putting money in a retirement account is getting penalized 10% for early withdrawals before age 59.5. Plus, you typically can’t tap a 401(k) or 403(b) unless you have a qualifying hardship. That rule discourages you from tapping your account, so it keeps growing for retirement.
So, never put money in a retirement account that you might need for everyday living expenses. If you avoid expensive early withdrawals, the advantages of using a regular or solo 401(k) far outweigh the downsides.
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That's all for now. I'll talk to you next week. Until then, here's to living a richer life.
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