Pros and cons of a 401(k) plan

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Spoiler alert: 401(k) plans have almost no cons

For many investors, a 401(k) plan is the primary way they save for retirement. A 401(k) is an investment account that is sponsored by a company, allowing its employees to make pre-tax contributions directly from their paychecks. These contributions are usually calculated as a percentage of the employee’s gross salary and, in many cases, are matched by the company up to a predetermined point.

While we may not have time to list 401 reasons to love the 401(k), we’ll share some of the many compelling reasons to get on board.

The many pros of a 401(k) plan

In a 401(k) plan, the employee generally has control over how the funds are invested and selects his or her investments from a predetermined menu provided by the employer. The investments on this menu are usually a selection of different mutual funds. Some plans also offer suggested portfolios for employees to select from or target date mutual funds, which adjust to include more fixed income as the employee nears retirement age.

Employee contributions are vested immediately (vested means you own your personal contributions completely). Additionally, 401(k) plans are portable – you can switch companies and transfer your current 401(k) account with you.

Just as important, 401(k) plans are an efficient way to reduce your current income taxes, because all your contributions are pre-tax and therefore reduce your taxable income, helping you keep more of your income and pay less in taxes!

401(k) plans work: The proof is in the numbers

Companies may match employee contributions, up to a limit, which helps employees save and invest even more. For instance, if a company matches contributions up to 3%, then an employee who contributes 3% of her income would actually have 6% invested in her 401(k) each year. With compounding over time, especially for those who begin saving and investing early, this can make a significant difference at retirement.

The chart below shows the hypothetical impact of contributing 3% of a $50,000/year income to a 401(k) plan every year, with and without an equal employer match, over 30 years. The data assumes an average 7% portfolio return (which is the historical average annual return of the S&P 500).

Chart 1: Hypothetical growth of a 401(k) over 30 years
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Yellow line: 3% with no company match
Green line: 3% plus 3% company match

This chart is for illustrative purposes only, but you’ll see that a 3% contribution on a $50,000 annual salary (which is $1,500 per year or $125 per month) would grow to be worth $142,691 in 30 years. And if you’re able to take advantage of an employer match, that same contribution could grow to $283,382 in 30 years! Similarly, increasing your own contribution rate could have a profound impact on your future savings.

Contribution limits for 401(k) plans

Like IRAs, 401(k) plans have annual contribution restrictions. For 2018, an employee can contribute a maximum of $18,500 before tax if they’re younger than 50, and $24,600 if they’re older than 50. As with an IRA, you need to be 59 ½ to begin withdrawing from your 401(k) without a 10% penalty. Learn more about 401(k) loans and penalty-free withdrawals in our related posts. Many employees should take advantage of 401(k) plans if they are available, because they have higher contribution limits than IRAs.

401(k) plans are often the best way to save for retirement

For many people, a 401(k) plan’s matching contribution feature and tax benefits make it an integral foundation for retirement investing. Not taking advantage of tax benefits could be leaving money on table, and the earlier you start contributing, the better off you can be for retirement because of compounding. If you need a reminder of the growth potential over time, just look at the chart above. Then go start contributing to your 401(k) or increase your contribution rate. You’ll be so glad you did down the road!

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