Are 401k plans worth it?

Are 401k plans worth it? If you’re pondering this retirement plan, there are quite a few pros and cons to be aware of. You’re in the right place – because we’re going to take a deep dive into these for you today.

Retirement planning is a tricky thing for many Americans. Retirement involves a person making the choice to leave the workforce. However, once a person leaves the workforce, that means they lose their source of income.

Without a consistent source of income, many people cannot keep up with their bills like a mortgage, car payments, etc. In fact, many people don’t even realize that there are a lot of different accounts that can help them reach their goals. One popular option for retirement savings is a 401(k) plan.

But are 401k plans worth it? The answer may surprise you…but down below, we’ll cover everything you need to know on the topic. First, a brief overview of 401k plans.

What is a 401(k) Plan?

This specific retirement account is only available to employees. That’s because employers are the ones who offer this option! This is popular amongst employees because it helps them save for retirement, and comes along with tax benefits, and contribution benefits.

These accounts are investment accounts. That means that the funds you contribute to the account will go towards investments. Usually, the investment options available are limited by the options that the employer chooses.

Even though these accounts come with a variety of benefits, there are rules around these types of plans. One of the biggest rules is the contribution limits in place. In 2021 the contribution limits for a 401(k) were:

  • $19,500 for people younger than 50 years old
  • $26,000 for people older than 50 years old

On the other hand, the contribution limits for 2022 were:

  • $20,500 for people younger than 50 years old
  • $27,000 for people older than 50 years old

That means that these limits can change every year! It is important to be aware of these changes so you can make the most out of your 401(k).

Different Types of 401(k) Accounts

It’s also important to keep in mind that the type of plan will impact how it works. There are two main types of 401(k) accounts. There are:

  • Traditional 401(k)s
  • Roth 401(k)s

Understanding Traditional 401(k) Plans

Typically when people think of a 401(k) account, they are likely thinking of a Traditional 401(k). When an employee makes a contribution to this type of account, they will use pre-tax dollars. Why is that important? Since no taxes have been applied to the funds, that means that individuals can use the contribution as a tax deduction.

Tax deductions are a benefit because they can reduce the taxable income of the employee. For example, let’s say an employee made a $3,000 contribution towards their Traditional 401(k) account. If their annual income for that year was $35,000 then they could apply the tax deduction and only pay taxes on $32,000 worth of income.

As we said earlier, there are rules that come along with these types of accounts. Besides contribution limits, there is required minimum distribution (RMD) rules. RMDs require the account holder to begin taking funds out when they are 72 years old. When a person takes funds out of their account, it is known as a distribution.

When you take out a distribution from your account, it will be taxed at the standard income tax rate (since the funds in the account are pre-tax). That means you can expect to pay taxes on what you take out! The standard income tax rate is determined by your income level. However, there are exceptions to this rule! For example, an exception would be if you were born before January 2nd, 1936, and choose to take your distribution out as a lump sum.

Understanding Roth 401(k) Plans

Now that you have a better understanding of Traditional 401(k) accounts, it is time to get a better understanding of Roth 401(k) accounts. The funds that people put into this account are after-tax. That means that taxes have already been applied to the funds before they are placed into the account. However, even though a person will not be able to see the tax benefits right away, they will see them down the line.

That’s because the distributions that you take out of this account will not face any additional taxes! Just like with a Traditional 401(k) account, there are rules that come along with Roth 401(k) accounts. Besides contribution limits, there is required minimum distribution (RMD) rules. RMDs require the account holder to begin taking funds out when they are 72 years old.

When taking funds out of a Roth 401(k) account, it is important to remember that the distributions must be qualifying. Qualifying distributions meet requirements like:

  • 5 years have passed since the account holder opened and deposited funds into their account
  • The account holder is at the retirement age for this account which is at least 59 and ½ years old at the time of the distribution.

Are 401(k) Accounts Worth It (Even If They Don’t Offer Employee Matching Programs)?

Now – it’s time to address the main question you came here with. Are 401k plans worth it – or are your funds better invested elsewhere? As you can imagine, there isn’t a one size fits all answer. It will vary based on your unique situation.

With that said, any account that can help you towards your retirement goals is worth it. Regardless of the type of 401(k) plan you choose, the funds ultimately go toward your retirement. Whether or not an employer will match the funds you put in, you shouldn’t bank on that benefit specifically. Instead, focusing on saving for your retirement will make the account worth it!

Pros of 401K plans

Just like anything you consider in life, you will want to make sure you look at the pros and the cons of this plan. Let’s start off by looking at the pros! Some of the benefits that come along with this retirement account are:

  • Federal Legal Protection
  • Potential Employer Matching
  • High Yearly Contribution Limits (If Offered)
  • Free Investment Advice

Cons of 401K Plans

While these are some nice benefits, there are some drawbacks to be aware of as well. Some of the cons that come along with this type of account include:

  • Potentially Limited Investment Options
  • Potentially Higher Account Fees
  • There May be Early Withdrawal Penalties

While these drawbacks may not necessarily outweigh the benefits, it just depends on the person. For example, if you are someone that doesn’t want to deal with limitations when it comes to your investment options, then you may not like a 401(k). That’s because instead of being able to invest in whatever you want, you may be limited by the investment options that the employer chooses.

The Verdict

Ultimately, only you can determine if a 401k plan is worth it. Take a look at the pros and cons above and see which outweighs the other.

And if you still have questions, your best bet is to consult a financial professional. They will help you analyze your own financial situation, and your retirement goals, and from there, form a recommendation that maximizes the potential of your retirement account.

What are 401(k) Alternatives?

Yes – 401k plans can be worth it in certain circumstances. But, there are also some great alternatives out there you should consider before making a decision.

Earlier we said that only employers offer 401(k) plans. That means that if your employer doesn’t offer one, you will not be able to benefit from this option. However, there are other opportunities to consider! An alternative to 401(k) plans are Individual Retirement Accounts (IRAs). Just like 401(k) plans, there are two types of accounts that you can choose from. You can choose either a:

  • Traditional IRA
  • Roth IRA

Wait…are IRA ad 401k plans the same? No – but, just like 401(k) accounts, there are contribution limits that people will deal with. For example, in 2021 (and 2022) the contribution limit for an IRA is :

  • $6,000 for individuals younger than 50 years old
  • $7,000 for individuals older than 50 years old

What is a Traditional IRA?

Just like a Traditional 401(k), these accounts use pre-tax funds towards investments. The Internal Revenue Service (IRS) will not assess capital gains or dividend income taxes on these accounts until funds are taken out. That means that the funds in these accounts grow tax-deferred! Once it is time to make a withdrawal the account holder should be at least 59 and ½ years old.

Typically the contributions that a person makes into these accounts can be considered a tax deduction. For example, let’s say you contribute $2,000 to your Traditional IRA. In that same year, your taxable income was $40,000. Instead of paying taxes on $40,000, you can use the tax deduction of your contribution to reducing your taxable income to $38,000.

However, just like with a Traditional 401(k) the tax savings are seen at the beginning with the tax deduction. When it comes time to take funds out of the account, they will be taxed at the standard income tax rate.

What is a Roth IRA?

Besides a Traditional IRA, there is a Roth IRA. Just like a Roth 401(k), these accounts use after-tax funds. However, since the funds that go into the account already deal with taxes, that means individuals have the chance to make tax-free withdrawals. In order for the withdrawals to be made at the tax-free rate, they need to be eligible.

In order for the distribution to be eligible they will need to meet factors like:

  • 5 years have passed since the account holder opened and deposited funds into their account
  • The account holder is at least 59 and ½ years old at the time of the distribution.
  • Funds taken out are used towards rebuilding or buying a first home for the account holder or qualifying family member (this has a $10,000 lifetime limit)
  • The account holder becomes disabled
  • Assets go towards the cost of having or adopting a child

If none of the above conditions are met, then the distribution will not qualify to be tax free. Besides dealing with income tax, there will also be up to a 10% penalty. Luckily, there are also exceptions to the tax rate and penalties.

Are 401K Plans Worth it? Wrapping Things Up

So, are 401K plans worth it? We hope this article helped you gain clarity on the subject. Yes – they can be worth it, but this retirement plan isn’t for everyone. You should carefully weigh the pros and cons we’ve outlined above and come up with your own answer.

Moreover, you should evaluate some of the alternatives to see if you are better suited to a different retirement plan. There are so many different investment options that you can create a financial future with!

If you want to learn more about retirement savings accounts, we have a great resource on how 401k matching works. You can also learn about whether 401ks can be garnished, how 401ks works for self-employed people, and what to do with your 401k when switching jobs. Daily Prosper is here to help you feel empowered in controlling your financial future!

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