A well-funded retirement rarely happens by accident. It takes planning, patience, and most often involves the use of tax-advantaged accounts such as a 401(k). There are many 401(k) benefits to consider, which can accelerate retirement savings. Here’s what a 401(k) offers and how it can be an important part of one’s retirement plan.
What is a 401(k)?
A 401(k) is an employer-sponsored, tax-deferred retirement savings account. These long-term investment vehicles are typically funded using paycheck withholdings and can be invested in any number of funds chosen by the account sponsor.
What are the advantages of a 401k?
So, what does a 401(k) do? It allows employees to automate their retirement savings and get in on a workplace-sponsored program with the potential for an employer match.
- Tax-advantaged savings. With a traditional 401(k), contributions are made with pretax dollars. Any contributions are also tax-deductible, meaning the investor can reduce their taxable income for that year. Instead, investors pay income tax on the funds when they withdraw them in retirement, when their income tax rate may be lower.
- Set it and forget it. Employees usually elect how much money they want to defer from their salary to a 401(k) once during the calendar year. Once the amount is set, the savings are allocated from their paycheck to their retirement account automatically.
- Funds accessible via loan. Some 401(k) plans allow for loans against the account balance prior to retirement. While the loan will need to be repaid and incurs both interest and fees, this can offer another safety net for account owners who need to access the funds earlier than age 59½.
- Potential employer match. With employer matching contributions, investors simply contribute to their account as usual while their employer contributes a matching amount, either dollar-for-dollar or as a percentage of the employee’s contribution, up to an annual maximum.
Advantages of a 401(k) for employers
401(k)s have benefits for employers as well. A good 401(k) program can act as a recruitment and retention tool. Employer-matched contributions also serve to reduce the company’s taxable income for the year. These matched contributions—in addition to the hours required to implement and distribute them—are tax-deductible for the company.
What are some drawbacks and limitations of a 401(k)?
As an employee, there are a few downsides and limitations to keep in mind when it comes to investing in a 401(k).
- Limited control. Employees can only choose from the plans offered by their workplace, and these funds may not suit their preferences and come with high fees.
- Tax-deferred, not tax-free. Because 401(k) plans offer tax advantages upfront, distributions in retirement are also subject to ordinary income taxes. While there are Roth 401(k)s—which are funded with after-tax dollars and may be withdrawn tax-free—it’s up to the employer to offer one.
- Contribution limits. 401(k) contributions are limited to $20,500 per year, as of 2022. For employees over 50, a catch-up contribution of up to $6,500 per year is allowed, bringing the maximum contribution limit to $27,000. This may be enough for many employees, but those who wish to set aside even more can consider contributing to an IRA or a non-tax-advantaged investment account.
- A lack of access to the funds. The savings held in a 401(k) account are meant to be locked away until age 59½. While certain loans against one’s 401(k) are allowed and there are some exceptions for hardship situations, most account owners will be unable to touch that money until retirement age.
Drawbacks for employers
For employers, offering 401(k) plans can be time-consuming and expensive to maintain. Depending on the company’s size and the plan, it may require a dedicated administrator or even a team to manage. And whether an employer offers to match contributions dollar-for-dollar or just matches 50 cents per employee dollar contributed, this is still money out of the company’s pocket.
The bottom line
A healthy 401(k) account can build a strong foundation of retirement savings, which can support future retirees for decades to come. These workplace-sponsored accounts give employees access to curated investment funds that they can use to grow their savings over time. They also can make it easy to contribute tax-deductible dollars each month and—with the potential for employer contribution matches—even free money.
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