What is a 401(k)?
A 401(k) is a type of retirement plan that many employers offer. A 401(k) is a defined contribution plan. Employees make contributions through payroll withholdings, and employers typically match some portion of employees’ contributions.
Every employer’s 401(k) offering will look a bit different. Companies may delay when they start matching investments. They match a certain % of your pre-tax income. They may delay when you are vested in your 401(k) (i.e., when you own it. If you leave an employer before you are vested in your 401(k), you lose it. It does not come with you if you are not vested).
I Didn’t Know 401(k)s Were So Controversial
If you say that using a 401(k) is part of your investing strategy – some will return a scoff of disgust. This is especially true in the FI/RE community.
That said, it seems that most people agree that you should contribute at least enough to get your employer’s match. That is, of course, true – and you should use your PTO, too. Not getting your employer’s match is like choosing not to cash a couple of your paychecks. You are leaving money on the table that your employer has already set aside for you. It is part of your compensation package.
Why Do 401(k)s Get So Much Hate?
Limited Investment Options. You do not have the ability to truly self-direct investments in your 401(k). You must choose from the menu of options your employer offers you – and too often, the menu is lacking. 401(k)s tend to have limited investment options.
The options are typically limited to mutual funds. Mutual funds often have higher fees (you need to pay the mutual fund managers to pick investments and do marketing) that eat away at your returns over time. I personally prefer ETFs to mutual funds for this reason. You are usually unable to invest in stocks, bonds, real estate, or ETFs through a 401(k).
Fees on Fees. In addition to paying fees for mutual funds in your account, you may also pay fees to the administrator of your 401(k).
Retire When You Want. The FI/RE community does not like any retirement plan that has restricted access based on age. You typically cannot withdraw money from your 401(k) without a penalty until you are 59.5 years old. Some plans allow you to start withdrawing at age 55 as long as you have already been retired for at least 1 year. Some occupations (police officers, firefights, and EMTs) may be allowed to start taking withdrawals at age 50.
Taking a 401(k) distribution too early will result in a federal tax bill at your marginal rate and a 10% penalty on the amount you withdraw.
For people aiming to retire in their 30s or 40s – this is a problem. So the FI/RE community steers people towards investing in triple-taxed brokerage accounts just because you have free access to the money at any age.
Distributions are Taxable. When you retire, you will pay taxes on your 401(k) distributions. Other types of investment accounts have tax-free distributions, such as HSAs and Roth IRAs. 401(k) distributions in retirement will be treated as ordinary income. Something to think about: will your tax rate be higher or lower in your retired years?
What Are the Benefits of Using a 401(k)?
Tax-deductible contributions. Under the current tax plan, your 401(k) contributions are deducted from your taxable income, lowering the amount of taxes you owe. (Under future tax plans, this may change to allow you to take a tax credit of 24% of your contributions – so still tax-advantaged, but in a different way). Currently, the maximum amount by which you can reduce your taxable income via 401(k) contribution is $19,500 (for single filers under age 50) or $26,000 (single-filers over age 50). That might just be enough to push you into a lower tax bracket!
Bankruptcy Protection. 401(k)s are typically protected in the case of bankruptcy. As long as your 401(k) is an ERISA-qualified plan, it is off-limits to creditors. The leading cause of bankruptcy is medical debt. Medical emergencies can happen to anyone, and therefore, so can bankruptcy.
Loans. The IRS allows you to take a loan against your 401(k) – up to $50,000 or the total vested amount (whichever is less). Whether or not you can take a loan against your 401(k) will also depend on if your employer allows it, and you may need to pay it back immediately in the event you change employers.
Hardship Withdrawal. You can make early withdrawals if you face hardship. The IRS allows for early distributions in some instances of immediate and heavy financial need. The funds typically do not need to be repaid, but you may owe taxes on them.
Ownership. You own your 401(k), and it stays with you even if you leave an employer (provided that you are vested). Leaving an employer may also trigger an event that allows you to “rollover” your 401(k) into an IRA. With this option, you may be able to self-direct the funds and have better investment options.
If You Like Your Money, You Can Keep It
Should you rely solely on a 401(k) as your retirement and/or investing vehicle? No, that is probably not a great idea for most people. But can it be a valuable component of your investing/retirement strategy? Yes, having a multi-faceted retirement plan is usually a good idea. Just as you should not put all your eggs in one basket, you would not want to put all your eggs in a 401(k).
It is an excellent goal to work towards maxing out all tax-advantaged investments available (and keep investing beyond that!) Learn more about tax-advantaged investing accounts here.