When we talk about retirement, one account always comes to mind for everyone: the 401(k). It’s been the go-to for retirement needs for one simple reason: if you work for a large employer, there’s likely a chance there is an employer retirement plan available.

However, this account is not perfect. Some cons steer people clear away from the vehicle altogether. We will lay all of these out here: why it’s great, why it’s not great, but most importantly, everything you need to know. So let’s dive in:

What Is a 401(k)?

A 401(k) is an employer-sponsored retirement plan. Employers use it to incentivize their employees to save for retirement and as a recruiting vehicle. As a retirement account, it offers unique perks. By default, the 401(k) is a pre-tax account that is great for deducting contributions and tax-deferred growth.

This component helps the funds grow over time without realizing any trades or income inside yearly compared to a taxable account. If allowed, your 401(k) might also have a Roth component, allowing you to grow and distribute these funds tax-free. These are similar to individual accounts like the IRA but have noticeable differences. So let’s compare the two.

IRA vs 401(k)

An IRA is an individual retirement account you’d typically open independently. The top highlights include:

• Contribution limit: $7,000 (2024)
• Catch-up contribution limit at 50+: $1,000
• Two different accounts: Traditional IRA or Roth IRA
• Income limits on Roth IRA contributions
• Deduction phaseouts on Traditional IRA

Now compare this with a 401(k):

• Contribution limit: $23,000 (2024)
• Catch-up contribution limit at 50+: $7,500
• Contributions can be made via pre-tax or post-tax
• No income limits on the Roth side
• No deduction phaseout on pre-tax

It’s Not Just Your Paycheck

The biggest difference between this and an IRA is the employer component of the plan. In addition to what you contribute, your employer is allowed to contribute as well. This employer contribution is often referred to as a “match.”

Typically, there is a requirement to receive the match. It’s typically done with an employee's contributions, hence the title “match.” But that’s only one part of the equation. Matches are given via a vesting schedule, which is a program that gives employees access to benefits after they've worked for a company for a set amount of time. This is used as an incentive to retain employees at their firm. Once it vests, it’s theirs to keep.

For example, many plans have a 2-6 year vesting schedule. This means the vesting starts at the 2-year mark, and each year 20% is vested until fully vested at the 6-year mark. See the visual below as an example:

A Larger Contribution Size

If the employee contribution and matches weren't enough, there is a third element that could be added to the 401(k). If your employer allows it, you could potentially contribute after-tax contributions into your 401(k). This money has already been taxed and isn't subject to the employee's $23,000 limit. In addition, this could potentially be used as a conversion to a Roth within the 401(k) or to an outside IRA. This process is called a Mega Backdoor Roth and must also be allowed by the employer plan.

These three combined can equal $69,000 for 2024, excluding the catch-up contributions. Not many vehicles allow such a substantial income to be deposited into a tax-advantaged account. Below is a complete visual of how this contribution limit is broken down:

On the surface, it seems like a no-brainer to be involved. But of course, not every investment is flawless, especially the vehicles within which it is invested. With great benefits do come restrictions to note.

Cons of a 401(k)

• Vesting Period: Just because you get your match doesn’t mean it’s 100% yours yet. Early termination before the vesting period kicks in means you won’t get to keep your match full.
• Early Penalties: Tax benefits come with big restrictions. If taken out before 59 1/2 years old, taking funds out is subject to a 10% tax penalty in addition to ordinary income taxes. There are some exceptions to this rule, such as:
  • If you leave your employer or left your job during or after the year you turn 55 (age 50 for certain public safety employees).
  • If you incur a disability or death.
  • Distributions are made as part of a series of substantially equal periodic payments.
  • Paid for unreimbursed medical expenses that exceed a certain percentage of your adjusted gross income.
  • Etc.
• RMD: One significant drawback of a 401(k) is the requirement to take Required Minimum Distributions (RMDs). Starting at age 73 (as of 2024), you must begin withdrawing a certain amount from your 401(k) each year. Failure to take the RMD can result in hefty penalties. This only applies to pre-tax 401(k)s, not Roth 401(k)s.
• Investment Selection: One issue with this account is that you cannot freely choose any investment in the marketplace. The plan administrator will have a fund selection ready for you, but it will limit your choices overall. There may not be enough funds to suit your preferences.
• Fees: In addition to the funds' fees, the 401(k) plan typically has an admin fee. These will vary from plan to plan, but they may be passed on to the employee.

How a 401(k) Makes It Simple

One of the most underrated perks a 401(k) provides is how easy it is to get started and keep going. With the account typically already set up for you, in just a few minutes, it can be accessible to:

• Choose a contribution size
• Select an investment portfolio
• Decide the tax contribution type
• Have the portfolio managed and rebalanced

The above is done directly from your paycheck. This allows you to stay on top of your game plan without putting too much work behind the scenes, which is a huge perk when it comes to putting your actions on autopilot.

So while it does have its limits, it can be a fantastic option to build long-term wealth at the edge of your fingertips. The 401(k) is more than just OK!

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