During periods of market volatility or decline, it is logical to question if taking a chunk of your paycheck for 401(k) contributions is worth it. If your retirement account balance is negligible or you’re in a job that offers a 401(k) plan and you’ve never signed up, it can be difficult to envision how a 401(k) could help you stay afloat. After all, isn’t it more important to use your money today than to add it to a pile you might be able to use in the future?
We would argue that as long as you are still receiving a paycheck and don’t have high interest rate debt, you should keep up (or start) your 401(k) contributions.
Properties of a 401(k)
A 401(k) plan is a retirement savings account that allows you as an employee to put part of your gross salary into long term savings and investments. Many employers also match the employee’s contribution up to a maximum percentage. This account qualifies for special tax benefits under IRS guidelines, but on the flip side you might incur a tax penalty if you withdraw money before a set age limit.
Within the plan, you have options for investments—usually a variety of mutual funds and index funds—based on your employer.
Why 401(k)s can be a great idea
401(k)s are a part of your financial toolkit and should be utilized accordingly. 401(k)s can be a great choice for investors because:
They’re easy to use: Many employers now automatically sign up eligible employees for their 401(k) plan so there’s not a lot of paperwork to fill out or keep track of. Most providers also have easy to use online platforms that make it easy to monitor and track your investments
Employer matching: This basically means that your employer is contributing into your 401(k) plan with you and helping you save for retirement. Taking advantage of employer matches basically means you’re getting more money put into your retirement account
401(k)s can help lower your taxes: the money you put into your 401(k) plan reduces the amount you owe to the IRS
401(k)s are meant for long term investments: You don’t have to pay taxes on capital gains or dividend growth on the assets in your 401(k) until you withdraw from the account. If you start investing now, your money can grow tax free for a long period of time
You can use 401(k)s for other big money moves: Once you’ve built up a substantial balance in your 401(k), you can start reaping some of the lesser known benefits of a 401(k) plan. For example, your 401(k) plan can serve as collateral for a loan and you can borrow from your 401(k) to fund a down payment or home renovations.
It can be a painless way to save: Most employers can deduct a percentage of your paycheck automatically, which means you don’t have to worry about spending that money accidentally
Problems with 401(k)s
Like we mentioned above, 401(k)s are investment tools and that means they might not be perfect for every situation. There can be a few scenarios where a 401(k) might not work for you:
Limited choice of investment funds: employers usually outsource the management of 401(k) plans to a brokerage or investment provider. While these providers do a good job of offering options with a range of risk and return profiles, you can’t sign up for a competitor’s funds or specific mutual funds. Your choices typically range between the following (in order of generic risk):
- Money-market funds or stable value funds
- Core bond funds
- Large-capitalization funds
- Small-capitalization funds
- International funds
Limited choice of asset types: Another way you might be limited as an investor within a 401(k) is in asset classes. For example, you cannot usually buy alternative assets like cryptocurrency within a 401(k). An argument can be made that cryptocurrency is unstable and unpredictable in the long run and thus not suited for a retirement account, but the same reasoning does not apply to real estate investments which are also difficult to do within a 401(k).
High fees: Given the choice of providers and brokerages, you might be limited to funds that charge high fees. These fees can be disguised as:
- Participant fees
- Itemized costs for services such as withdrawals
- Higher fund expenses
These fees can be upward of 1.5%, whereas ETFs and REITs available on the stock market charge 0.5-0.9% on assets.
Not flexible: If you’ve ever tried to roll your existing 401k plan to a new provider after switching employers, you’ll know just how painful it can be to do so. Because investment providers benefit from the growth in your assets over many years, they can unfortunately make it difficult for you to close your account with them. An investment provider can have unique forms, processes, and timelines you need to work with when switching providers.
If your employer offers 401(k) plans, it is a good idea to take advantage of this offering. Many employers match some or all of your 401(k) contributions, but if you choose not to contribute to your own plan you will also forfeit the employer match. We would recommend anyone who is starting to save for retirement to look into 401(k) plans because of all the benefits they bring to a financial portfolio: they’re easy to use, grow money tax free for many years, and have other fringe benefits.
Lastly, the current state of the economy has shown us that the long term trends of the stock market and the freedom that comes from having a retirement savings account are also very compelling reasons to start or grow your 401(k) contributions.