A 401(k) is a tax-advantaged retirement account that may be available as an employee benefit through your employer. This type of account can help grow your money over time—and your employer might match some or all of your contributions. A 401(k) can help you build your nest egg, but there are some downsides to consider. Whether it’s the right way for you to invest for retirement will depend on the specifics of your workplace retirement plan and your financial strategy.

Pros of 401(k)s

Tax Benefits

A 401(k) offers several tax perks, enhancing your financial health during your working years:

• Tax-Deductible Contributions: Contributions to a 401(k) can be deducted on your federal tax return. This reduces your taxable income and indirectly lowers your tax liability.
• Tax-Deferred Growth: Earnings, dividends, and interest in a 401(k) grow tax-free. You only pay taxes when you withdraw money from the account.

Employer Contributions

A significant advantage of a 401(k) is the potential for employer matching. Employers may match your contributions partially or dollar-for-dollar, boosting your retirement savings. According to Fidelity Investments, the average employer 401(k) match is 4.8%.

Automatic Contributions

401(k) contributions are typically made through automatic payroll deductions. You choose a percentage of your earnings to contribute, and this amount is withheld from your paycheck on a pretax basis. This automates the saving process, making it easier to build your retirement fund.

Investment Options

You can select your 401(k) investments or let your plan administrator choose based on your expected retirement age. Many plans offer target-date funds that automatically rebalance to become less risky as retirement nears.

Cons of 401(k)s

Taxable Withdrawals

Since 401(k)s are funded with pretax dollars, withdrawals in retirement are taxed as income. This could create a significant tax burden, especially if a 401(k) is your primary retirement income source. Early withdrawals before age 59½ usually incur a 10% penalty.

Contribution Limits

In 2024, the maximum contribution to a 401(k) is $23,000, with an additional $7,500 for those aged 50 and older. Overfunding your 401(k) can lead to double taxation on excess contributions. The contribution limits and taxable withdrawals might not fully support your retirement needs.

Required Minimum Distributions

You must start taking annual withdrawals from your 401(k) at age 73, known as required minimum distributions (RMDs). Failure to comply can result in penalties up to 25% of the amount not withdrawn. Your RMD amount depends on your 401(k) balance and a life expectancy factor determined by the IRS.

When Should You Invest in a 401(k)?

A 401(k) can be a valuable retirement savings tool. The power of stock market investing can help grow your nest egg, and you’ll benefit from tax advantages. Consider investing in a 401(k) if:

• Employer Match: If your employer offers a match, maximize it before considering other accounts.
• Hands-Off Investing: A 401(k) can be a set-it-and-forget-it account, especially with target-date funds.
• Tax Reduction: Contributions are tax-deductible, helping reduce taxable income during working years.

When to Consider an IRA Instead

An individual retirement account (IRA) might be a better option if:

• Self-Employment: You’re self-employed or lack access to a workplace retirement plan.
• Investment Control: You prefer choosing your broker and investments.
• Contribution Flexibility: IRAs offer more control over contributions.
• Roth Benefits: You want Roth account benefits but don’t have a Roth 401(k) option.
• High 401(k) Fees: Your workplace 401(k) has high fees.

In 2024, IRA contribution limits are $7,000 (or $8,000 if you’re 50 or older).

Can I Have a 401(k) and an IRA?

Yes, you can have both. Contributing to a Roth IRA and a 401(k) can diversify your retirement income. Roth distributions are tax-free, complementing the taxable withdrawals from a 401(k).

The Bottom Line

A 401(k) is an employer-sponsored, tax-friendly retirement account that can simplify saving for the future, especially with employer matching. However, remember the potential taxes on withdrawals, contribution limits, early withdrawal penalties, RMD requirements, and possible fees. Understanding these factors will help you decide, Is a 401(k) worth it? for maximizing your long-term savings.

If you ever need expert assistance or guidance on your credit journey, don’t hesitate to reach out to the Nerds! Additionally, stay updated with the latest tips and information by following us on Facebook, Instagram and TikTok!