9 Surprising Advantages of 401k Plans
Why you should invest more in your company’s 401k
|Written by Tom Yeung, CFA | CDFA|
Investment Advisor & Fund Manager, Jurnex Financial Advisors
In this article, I’d like to cover the nine surprising advantages of 401(k) plans. That’s because saving for retirement can take some extra motivation
Let’s face it. Saving for retirement can feel like physical exercise. Everyone knows to do it. But it’s hard to get motivated. I get it! The benefits of saving today won’t show up for DECADES in the future.
It becomes second nature to save more once you learn about the nine surprising advantages of 401(k) plans.
What’s a 401k plan?
Before we get started, let’s take a look at what 401k plans are.
In short, a 401k plan is an employer-sponsored savings plan that allows you to defer taxes.
Instead of paying higher income taxes today, you can set money aside in a 401(k) and pay income taxes later once you qualify for a lower tax bracket in retirement. You can learn more about 401k plans in my Ultimate Guide to 401(k) Plans.
As always, I suggest all my clients talk to a qualified investment pro before making any financial decisions. That’s because saving for retirement is so crucial for your future self, so it’s always worthwhile to make sure you’re on track. However, to get you started, here are the nine surprising advantages of 401(k) plans.
The nine surprising advantages of 401k plans
Want some motivation to invest more in your 401k? Here are 9 key reasons.
1. Lots of resources
Around 75% of working Americans have access to either a 401(k) plan or 403(b) (for public-sector workers).
And participation rates are staggeringly high. A study by Vanguard showed that plans with automatic enrollment had participation rates of 91%. And these days, 48% of employers now offer automatic enrollment, up from just 2% in 2004.
How does the popularity of 401k plans benefit YOU?
1. Benefits of scale. The more people who invest, the lower the costs become for everyone. Expense ratios of target-date funds are typically 0.08% or lower.
2. Better support. Greater popularity means more companies offering greater informational resources.
2. 401(k) plans are mindlessly easy to manage
It’s easy to get started on 401(k) plans because, unlike IRA’s, 401(k)’s are employer-sponsored. That means your employer is responsible for all the paperwork, not you.
- Diverting salary. Once you choose how much you want to invest, your employer will automatically deduct that amount from your pay and allocate it on your behalf.
- Taxes. Your employer takes responsibility for recording your 401(k) plan contributions on your W-2 form. As long as you don’t take out any distributions, you don’t have to file additional 1099 forms.
- Management. As a sponsor, your employer is responsible for managing plan service providers and compliance with IRS rules.
3. High contribution limits
401(k) contribution limits were $19,000 in 2019, compared to just $6,000 for IRAs.
This high contribution limit gives you the flexibility to save additional money for retirement. For example, you might have particular years in which maxing out your 401(k) becomes impossible. Perhaps you have children in college or face significant one-time expenses. But once these one-time expenses end, you can quickly catch up with savings by maxing out your 401(k).
Also, 401(k) plans allow catch-up contributions for people over age 50. This allows people to contribute an additional $6,000 to their 401(k) plan, bringing the total up to $25,000 per year.
These higher contribution limits pay off
An individual who maxes out their IRA from age 35 until age 65 can expect a nest egg of $3.2 million by the time they retire, given an 8% average rate of growth.
4. The 55 Rule
Typically, 401(k)s and IRAs allow penalty-free withdrawals only once you reach age 59.5. Otherwise, the IRS levies an additional 10% tax penalty on early withdrawals. However, one of the special advantages of 401k plans is a special rule called The IRS Rule of 55.
What is the IRS Rule of 55?
This IRS rule allows individuals to withdraw money without penalty at age 55. To qualify, you either need to 1) retire from the workforce or 2) get separated from your employer. Designated public safety employees (federal, state, or local government), can do this as early as age 50.
Why withdraw money early?
Withdrawing money 4.5 years early might not seem like much. But if you need the money, let me tell you now.
My father passed away in his mid-fifties. For those in ill health, having access to money earlier gives the flexibility for those who need it most. And even in less urgent cases, many middle-aged adults want to use their 401(k) savings to buy a house in a retirement community or help children pay for college. And having access to penalty-free cash can make these goals far easier to achieve.
5. 401(k) plans reduce the temptation to overtrade
Because 401(k) plans are so easy to set up, most people maintain a healthy “fire-and-forget” mentality on their 401(k)s. According to Vanguard, 75% of 401(k) plan participants between 2014 to 2018 made ZERO trades.
Now, I always tell my clients to monitor and rebalance their portfolios. Having a position grow too large can make your entire nest egg overly dependent on a small number of stocks or funds. But the opposite can be even worse. Studies show that overtrading can cause investors to underperform by up to 6.5% per year.
What’s the best way to invest?
I like to tell my clients to invest like Rip van Winkle: the man who fell asleep for 20 years. The key to superior long-term investing is, well, thinking long-term.
Imagine being able to pick a handful of high-quality stocks and funds, and then falling asleep for 20 years. Would you sleep well? If your answer is “yes” you’re on the right track. And 401(k) investments can help you put retirement investing out-of-mind. You can read more about stock investing and diversificaion here.
6. Employer matching
According to Vanguard, 56% of all 401(k) plans have some form of employer matching. That’s when an employer will match all employee 401(k) contributions up to a certain dollar amount. Furthermore, 47% of plans offer immediate matching without a vesting schedule.
There is a wide variation in employer contribution policies. In 2018, Vanguard administered more than 150 different types of matching formulas. The most common matching method is $0.50 on the dollar on the first 6% of pay. The second most common is $1.00 on the dollar for the first 3% of salary, and then $0.50 on the dollar for the next 2% of pay.
Regardless of your employer’s matching formula, it’s generally wise to take full advantage of any employer matching. That’s because the additional cash will allow your savings to grow even faster. These percentages might seem small today, but thanks to the power of compound interest, the dollar amounts can grow significantly over time.
7. Roth 401(k). It exists!
Many people believe that only the Roth IRA exists. But did you know that Roth 401(k) plans also exist? In fact, as of 2018, 71% of 401k plans now offer a Roth feature
What is a Roth IRA/401(k)?
In a Roth IRA or 401(k), you contribute after-tax dollars into an account.
Think of it as buying investments with cash from your wallet. You’ve already paid income taxes on that cash. After that, all your Roth contributions become tax-exempt for as long as the IRA/401k exists. You’ll never have any capital gains or income taxes due on the assets.
How is this different from a traditional 401(k) or traditional IRA?
Traditional 401(k)s and IRAs only DEFER taxes. That means you’re avoiding income taxes today, but you’ll have to pay income taxes in the future when you withdraw money.
Having a choice between a Traditional and Roth 401(k) gives the benefit of tax diversification.
8. No capital gains tax
Usually, people investment 401(k)s to defer income taxes. But with overall tax rates going up, many people worry whether there will be any tax savings at all!
But don’t worry. Buried among the advantages of 401k plans are zero capital gains taxes.
You read that right. No capital gains. Ever.
For other investments, you have to pay capital gains taxes on any investment that has gone up in value.
- Short-term capital gains. If you buy and sell an asset within 12-months, you are subject to short-term capital gains taxes. Tax rates range from 10-37%, depending on your total taxable income.
- Long-term capital gains. If you hold an asset for longer than 12 months, the asset becomes eligible for long-term capital gains rates. Rates can range from 0-20%, though most investors fall between 15-20%.
With 401(k) plans, all your assets grow tax-free. No matter how much you trade, all gains can grow without triggering capital gains taxes. The only time you have to pay any taxes is when you withdraw the money as ordinary income.
9. Ability to borrow from your 401k
I typically tell my clients to reserve their 401(k) just for retirement. However, what if you need the money today?
Fortunately, there’s a good option. One of the advantages of 401k plans is that you can borrow from it.
For many people, borrowing from their 401(k) sounds like death itself. I don’t blame them. After all, this is money reserved for your retirement. But if you borrow from your 401(k) responsibly AND for good reason (such as a down payment on a house), then you might get the green light.
How is borrowing one of the advantages of a 401k plan?
Usually, the interest rate for 401(k) loans are only a point or two to higher than the prime rate. That means just 4-6% APR. That’s far lower than any credit card, and often much lower than any personal loan. You also have five years to repay the money.
I highly recommend people use a 401(k) loan only as a last resort. But emergencies can happen, and it’s good to know your 401(k) can be used for short-term if you do find yourself in a pinch.
Will YOU get the advantages of 401k plans?
Now it’s time to put that knowledge to work! And if you’re not sure where to start, don’t worry. The great news is you don’t have to do this alone. There are plenty of qualified retirement experts who understand the importance of investing your nest egg.
At this stage, I generally tell people not to worry about costs. It’s worthwhile to spend 3-4 hours with an investment pro today than make an investment mistake and not realize it for decades to come.
Where to find more resources
If you’re looking for even more investment tips, you’ve come to the right place.
That’s because I’ve helped invest client money for over a decade in the same old-fashioned way. And that’s to seek out great companies in great industries that can you can buy at a discount to their fair value. Sounds too simple to be true? Give me a call today, and I’ll show you that it’s still possible after all these years.
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