A 401(k) used to be one of the most popular ways to invest a portion of your income towards retirement while also getting some tax benefits. Since the economy has changed significantly since your parents started saving for retirement, many people are now wondering if they're still viable. This has led to the common question: "are 401(k)s worth it anymore?"
A 401(k) can still be a great way to save for retirement, but in order to fill that role, they need to be used wisely. You'll also need to know the best ways to diversify your 401(k) portfolio so that it can weather the ups and downs of the economy with resilience.
There's a lot to know about your 401(k). You'll need to know about your various contribution limits, some tips for diversifying them, and how they can help you out when tax time comes around. We're going to do a deep dive into all of that and more as we answer the question: "are 401(k)s worth it anymore?"
Is A 401k Worth It Anymore
When you ask if a 401(k) is really worth it, you should start with the list of benefits that they have. Firstly, your 401(k) will give you significant tax savings since it reduces your taxable income. Second, many employers offer a program that "matches" the employee contribution up to a point. Additionally, with many 401(k)s, you will have control over your investments, and while some may offer more control than others, you'll still have a say in how your money spends its time growing for your retirement.
The tax savings come from reducing your taxable income. Your contributions are taken out of your pre-tax or gross income, which means you get to save more of your money overall. This also means that since the contributions are taken out before taxes are, you will be taxed on less of your income. This could lower your tax burden to the next lower tax bracket in many cases, which can save you hundreds or even thousands in taxes each year.
There is a potential downside to these tax savings, however, although most people don't need to worry about it unless they hit relatively severe financial hardship. In these cases, an employee may have a few options, and they all have potential downsides. One option is that they can often take a partial withdrawal, which gives them a disbursement from their 401(k), while hitting them with a severe tax penalty, sometimes up to 50%. Another option is that they may be able to take a loan against their 401(k), which would be paid back with automatic deductions from their paycheck. This allows them to miss the tax penalty while sacrificing a portion of their income for the term of the loan. A final option is often called a "hardship withdrawal," and it means that if the employee experiences serious enough financial need, most or all of the 401(k) can be cashed out. This will generally require paperwork proof of the hardship, such as foreclosure or eviction notices, court documents, or similar proof, and it will also be subject to the early withdrawal tax penalties.
Another benefit of a 401(k) at a relatively good employer is that they will frequently match your savings up to a point. This means that for each dollar you put in, they may contribute up a dollar as well. In many cases, an employee matching program will match dollar-for-dollar up to a predefined limit, generally either a flat amount or a percentage of their contribution cap, and then they may reduce the matching to $0.50 per dollar after that or stop the match entirely until the next year. Matching programs vary wildly and are often a serious consideration when someone chooses to accept or decline a job offer.
The returns and investment flexibility of a 401(k) are another significant benefit. Most 401(k)s will allow the employee to determine how they want their money invested, and some offer a great deal of flexibility and customization. You may be able to choose from various investment strategies and risk levels. While some may limit you to choosing from mutual funds or similar investment tools, others may allow you to invest in any common security or market asset that you want. This is another way in which a 401(k) provided by one employer can vary significantly from a 401(k) facilitated by another employer who uses a different broker.
This investment flexibility and the long-term investment strategy that takes contributions from your check on a consistent basis also allow you a great deal of dollar-cost averaging. Dollar-cost averaging is an investment strategy based on prudent, consistent investment into a portfolio over a long period of time. While some people choose to simply make their contributions to whatever low-risk investment strategy their broker has outlined, allowing those funds to build up over time will also allow you to shift larger amounts of money into higher-risk investments with higher potential returns. This can all be done from your employer's 401(k) investment site or dashboard.
How Does A 401k Work
The 401(k) retirement plan was first created back in 1978 but really gained traction in the 1980s when it continued to grow. They were a natural outgrowth of their predecessors, which were pensions that were underfunded and paid a set amount to an employee upon retirement. Pensions required that the employer put aside money for the pension fund, but some high-profile failures to that model quickly made them obsolete in the face of newer 401(k) options.
There are no set limits for a 401(k), and rather than put the burden of savings onto the employer who historically wasn't the best at fulfilling that obligation, it relies on the employee to contribute what they feel is appropriate. In many cases, however, there are "matching" commitments that allow employees to multiply their savings quicker than contributing solo.
The basic premise of how a 401(k) works is that you'll have an account created for you, generally on an internal HR site for your employer, which you'll log into and set your contribution preferences. The contributions can often be made as a flat percentage of your pre-tax income or in specific dollar amounts from each check. The contributions will happen automatically, so it's an incredibly convenient and low-effort way of saving.
This is also where you'll set up your investment strategy and risk tolerance. In some cases, you may simply have an account created for you directly with a brokerage, in which case you'll be able to log in, buy and sell stocks and ETFs, invest in just about anything you want, or simply leave your cash in a money market account tied to your 401(k).
Does A 401k Gain Interest
While your 401(k) won't gain interest in the sense that your savings account would, it will likely produce a return that quickly outpaces the interest gains on a regular savings account. In fact, this is the entire point of investing. The interest rate of a checking or savings account is generally tied to the interest rates set by the Federal Reserve, which is largely decoupled and non-correlated to the market.
This means that by wisely investing your 401(k) contributions into things like index funds, you can easily make a much larger return on your contributions. In many cases, the interest you would earn on $100,000 in savings wouldn't even make up for the loss of value due to inflation. However, $100,000 in a 401(k) could produce considerable returns from index funds and dividend stocks or funds that would not only beat the inflationary decay but would actually grow your wealth.
Can A 401k Lose Money?
Just like any other investment, a 401(k) account could lose value if not properly diversified. Since it depends on the stock market, which can have a high degree of volatility, having "all of your eggs in one basket" could lead to significant losses if the market undergoes a large correction, recession, or even a crash. This means that even though you may like the leading index funds, you may also want to shift contributions into investment assets that have a lower risk.
Lower risk investments would include things like bonds, which are debt-based securities often held by governments or other large entities. Once you begin to have a significant amount of money in your 401(k), it could be worth the cost of speaking to an investment advisor to get the best strategy for the current economic climate.
Understanding Your 401k Can Make Your Investments More Effective
There are a lot of benefits to a 401(k) and very few, if any, drawbacks to them. The most significant things to remember are that you should contribute as much as possible while your employer matches and to make sure your portfolio is insulated from volatility with diversification.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.