If you’re interested in saving for retirement, you have plenty of options. You can tuck money under the mattress, purchase real estate, find a job that has a pension plan, or invest in the stock market.
Even in that last category, there are dozens of specific strategies and plans … including the well known, yet often misunderstood 401(k).
What is a 401(k)?
Known by the section of the Internal Revenue Code where they’re described, 401(k)s are contribution plans that employees sponsor as a form of retirement investing. More than 50 million active workers participate in employer-sponsored 401(k) plans, and more than half a million companies offer these plans.
In fact, 18 percent of all retirement assets in the United States are held in 401(k)s (roughly $4.5 trillion in assets). In 2019, the 401(k) contribution limit is set at $19,000 per person. For workers above the age of 50, catch-up contributions of $6,000 can be made for a grand total of $25,000 per year.
Not all 401(k)s are created equal, though. To start with, you have the option to choose between a traditional plan and a “Roth” plan. In a traditional 401(k), you contribute pre-tax income and pay the taxes upon withdrawal (after retirement).
With a Roth plan, you pay taxes up front, then invest the money. This enables you to make tax-free withdrawals at retirement.
There’s also an all but unlimited variety of choices with regard to how you may invest. You can select your own mix of stocks, bonds, mutual funds, etc. The 401(k) designation is simply a security blanket that wraps around the underlying investment and provides protection from taxes.
Four Benefits of 401(k) Investing
Since you have so many different retirement investment options, what makes the 401(k) so attractive? Well, for example:
- Legal protection. Under the Employee Retirement Income Security Act of 1974, you receive a number of protections with your 401(k). This includes a claims and appeals process to make sure you receive your benefits and a right to sue for benefits if the plan is mismanaged.
- Generous contribution limits. At $19,000 a year ($25,000 for people over 50), the 401(k) is by far the most generous when it comes to contribution limits. IRAs, for example, allow a maximum of only $5,500 in contributions per year.
- Matching funds. As an employee benefit, many employers choose to match a portion of worker contributions. For example, the company or agency may match 100 percent of what you contribute, up to 3 percent of your income. If you earn $50,000 per year, this means you could garner an additional $1,500 in retirement contributions totally free!
- Though the best strategy is to keep your money locked in your 401(k) until you reach retirement age, you have some flexibility to move the funds around in the meantime. For one thing, you may roll funds over into a startup loan. According to Seek Capital, you’ll have to follow a very specific set of rules in order to remain tax compliant (and it takes between 30 and 90 days to pull the money out).
Three Potential Disadvantages of 401(k)s
The 401(k) isn’t the perfect solution for everyone. It’s definitely one of the better options, but it does come with some potential disadvantages:
- Limited options. When you compare it to an IRA, a 401(k) offers far fewer investment options. Yes, you’ll have all the basic stocks, bonds, funds, and cash, but you’ll see relatively few other investment choices. For most people, this isn’t a problem; for others, it could be constricting.
- Account fees. 401(k) plans are expensive to maintain. And since you don’t have much control over them, you could get stuck with high account fees that eat away some of your earnings.
- Withdrawal penalties. When you put money into a 401(k), you’re essentially forgoing the option to use any of the money until you’re at least 59 ½. If you choose to access it before then, you’ll have to pay steep withdrawal penalties.
Putting it All Together
As you plan for retirement, it’s worthwhile to investigate the broad variety of investing options. While 401(k)s are the natural starting point for most people, you should also look at IRAs, CDs, real estate, REITs, and any other plans for which you qualify.
As you learn more about the choices on the marketplace, you’ll be able to make smarter choices.