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A 401(k) is a powerful and easy-to-enroll retirement account that can significantly increase your wealth and reduce tax liability. But, you’ll want to consider your retirement goals and diversify your investment vehicles accordingly.
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The 401(k) is a tried and true employer-sponsored retirement plan that may offer several benefits like matching contributions and tax advantages. It’s an important part of most retirement plans, but is a 401(k) really worth it?
Yes, you should take advantage of a 401(k) account. That said, regular 401(k) contributions alone won’t likely fund your full retirement. Diversification is important, and how valuable a 401(k) is to your retirement strategy depends on your goals and several other factors.
Explore 401(k) considerations and learn about other wealth-building assets for your retirement below.
Many employers that offer 401(k) benefits also provide matching contributions up to a certain percent of your salary. This can potentially double your contributions each month, which benefits compound growth to help you live off interest in retirement.
Skipping these benefits is leaving free money on the table. Even if your 401(k) isn’t a priority in your full retirement strategy, it’s still worth making regular contributions to maximize employer contributions and increase your overall balance.
You’d ideally match your employer match limit – typically 4-6% – but even minimum contributions are valuable. If you contribute $100 a month with a full match benefit, your balance will grow to $145,406 in 40 years with a 2% interest rate.
Verdict: Employer-match benefits are a unique perk to 401(k) retirement plans that you shouldn’t pass up. It’s essentially free money that grows with compound interest to support your retirement goals.
One of the largest 401(k) perks is that they’re tax-advantaged. This comes in two flavors – tax-deferred and tax-exempt accounts.
Tax-deferred accounts delay your tax payments until withdrawal, like traditional 401(k)s. These are great if you know your income will decrease by retirement, and you’ll owe fewer taxes. You also contribute pretax dollars, so these deductions reduce your taxable income for the year.
Tax-exempt plans earn money without a tax obligation. These are your Roth accounts funded with after-tax dollars. Your growth is tax-free, and you can withdraw without worrying about your tax bracket. Though, not all employers offer a Roth 401(k) option.
Most people benefit from a diversified mix of taxable, tax-free, and tax-exempt assets, but ratios vary based on your finances and goals.
High-income individuals usually prefer tax-deferred plans because they reduce their current taxes and expect to be in a lower tax bracket in retirement, when withdrawals will be taxed as ordinary income.
Roth accounts are good for moderate earners who expect their income to increase. You can always roll over into another Roth account, like a Roth IRA that may offer additional investment options.
Verdict: Your 401(k) contributions are tax-advantaged, and you can pay taxes now or later according to your circumstances and goals. Taxable investment accounts are still valuable for diversification, but they won’t help you beat the taxman.
Some retirement assets have income or contribution limits that can impact what accounts are available to you and how beneficial they are for your retirement plan. These limits don’t impact most people, but they make 401(k) accounts less attractive to high-income individuals.
The 2024 annual contribution limit is $23,000 – a $500 increase from last year. This also applies to 403(b)s, most 457 plans, and the federal Thrift Savings Plan.
Employees aged 50 and older have increased catch-up contribution limits by $7,500 for a total $30,500 annual limit.
These limits are higher than what IRAs offer at $7,000 in 2024. While nonretirement accounts have no contribution limits, they also miss out on valuable tax advantages.
The IRS restricts contributions to an income limit of $345,000 in 2024. This applies to all contributions, including employer-match.
If you earn more than $345,000, you can still defer up to $23,000 to your 401(k). However, your employer-match benefit will only apply up to your allowable compensation. So if you make $500,000 and get a full match, up to 4% of your salary, you’ll only earn $13,800 from your employer match, because it stops at $345,000.
Verdict: A 401(k) still benefits high-income earners, but consider other investment opportunities once you reach the income and contribution limits. The excess contributions might better serve you in an IRA or non-retirement account.
A 401(k) is easy to get and manage, but it’s not exactly free. Managers charge account fees for their services, and funds also charge investors. Account fees are a disclosed at enrollment, but you might be able to lower fund fees by choosing your own investment funds.
Penalties also apply for early withdrawals before age 59.5. The IRS will charge a 10% early distribution penalty in addition to any owed income taxes on the withdrawal amount. This means your money isn’t accessible or accommodating to life’s ups and downs.
There are some penalty exceptions. The SECURE 2.0 Act implemented a hardship withdrawal policy that allows one $1,000 distribution a year with a three-year repayment agreement.
Other withdrawal exceptions may apply to:
You can also take out a 401(k) loan and borrow up to 50% of your savings in a year (maximum $50,000) without penalties or taxes. You’re on the hook to repay the balance with interest, but all of the funds return to your 401(k).
Verdict: Always look into your investment fees to make smart decisions about your contributions and 401(k) funds. You might be able to self-direct your investments to avoid high-cost funds or discuss alternative 401(k) providers and opportunities with your employer.
401(k) plans are designed to be as simple as possible, which increases accessibility and financial support for a large portion of the population. The flip side is that investments are streamlined and often fairly limited, which isn’t ideal for experienced investors.
Investment fund opportunities typically fall into a specific category, which may include:
Most 401(k) plans are pretty passive, but you can self-direct your investments to align with a specific strategy that better suits your needs. Options are limited, and investment strategies vary based on your risk tolerance and goals.
Verdict: A 401(k) plan isn’t as customizable as other investments, which might increase accessibility for new investors while limiting growth potential for experienced investors. Consider self-directed investments or re-directing some of your contributions to actively managed assets instead.
Contributing to your 401(k) is an extremely valuable move because of tax advantages and employer-match benefits. That said, don’t get too cozy and think your 401(k) will cover your golden years.
A 401(k) relies on long-term growth with steady contributions to outperform the market and grow your wealth with compound interest. That means it sometimes loses money, and the passive strategy may be far less efficient than other active investments without tax advantages.
Learning how to balance your assets to maximize your tax strategy and drive your wealth to new heights is important. With the right tools, advice, and know-how, you can start investing in your retirement lifestyle.