Many for-profit employers offer 401(k) plans as a way to help employees save for retirement. Many people are familiar with the tax benefits of 401(k) plans, but that doesn’t mean they outweigh the drawbacks for everyone. Knowing the 401(k) advantages and disadvantages can help you decide if the plan is right for you and, if it’s right for you, how much you should contribute.
Tax Deductions for Contributions
Contributions to your 401(k) plan are excluded from your taxable income and aren’t taxed until you take distributions in retirement. If you pay a higher tax rate during your working years than you expect to pay in retirement, you’ll save even more. In addition, your employer may offer matching contributions on your behalf, so not only are you taking advantage of free money, it’s also excluded from your taxable income in the year of the contributions.
As long as the money remains in your 401(k) plan, the money grows without being taxed, which is the same as the IRA benefits. This tax-sheltered status of the account allows your nest egg to grow faster because none of your profits are siphoned off for taxes. For example, say you would normally pay a 20 percent tax rate on your investment income. If you sell shares for a $1,000 profit, you would have to pay $200 in taxes, leaving only $800 of the profits to reinvest. With the 401(k)’s tax shelter, you get to put the entire $1,000 profit back to work in a new investment.
Early Withdrawal Penalties
Once you contribute the money to your 401(k) plan, you usually can’t access your money without paying an extra 10 percent tax penalty on top of the income taxes until you turn 59 ½ years old. For example, if you have $100,000 in your 401(k) plan when you’re 40 years old and you took that money out to start your own company, you would have to pay not only the income taxes but also a 10 percent tax penalty on the distribution. Exceptions to the 401(k) plan early withdrawal penalty include if you retire after turning 55 years old, if you have tax-deductible medical expenses or if you suffer a permanent disability.
Disadvantages of Defined Contribution Plan
A 401(k) plan is a defined contribution scheme, which means that the amount you contribute is a set dollar amount, but you’re not guaranteed a specific amount at retirement like you are if you have a defined benefit plan like a pension. Instead, your retirement benefit depends on how well the investments in your 401(k) plan perform. If your investments do great, you could end up with a larger nest egg than you anticipated. However, if the investments do poorly, you aren’t guaranteed any minimum amount.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."