If you’re fortunate enough to work for a company that offers a retirement plan, it’s a valuable benefit you should never pass up. A 401(k) and its nonprofit version, a 403(b), are types of retirement accounts offered by employers. They allow you to contribute a flat amount or a percentage of your paycheck to a variety of investments, such as mutual funds and exchange-traded funds.
Many workers don’t enroll in retirement plans because they’re confused about the rules or mistakenly believe you must be an investing expert to use them. Instead of staying on the sidelines, get the facts about workplace plans and participate. The sooner you start making contributions, the more security you’ll have in retirement.
The pros:
1. You pay less income tax.
If you choose a traditional 401(k) or 403(b), your funds are invested on a pretax basis. Every dollar you contribute reduces your taxable income and your tax liability for that year.
You also postpone paying income tax on earnings in the account. That means you’re deferring all taxes on both your contributions and investment growth until you take withdrawals in the future.
2. You may receive free matching funds.
Many employers offer matching contributions to workers’ 401(k)s or 403(b)s. These additional funds can significantly increase your account value.
For example, a common arrangement is matching 100% of your annual contributions up to 3% of your income. If you earn $50,000 per year and contribute 3% or $1,500, your company would also contribute $1,500 to your account.
That’s like getting a raise for doing nothing. Always contribute at least enough to max out any free matching funds from your company.
3. You get a high contribution limit.
For 2018, the annual allowable contribution limit for workplace retirement plans is $18,500, or $24,500 if you’re over age 50. Make a goal to contribute no less than 10% to 15% of your gross income for retirement.
Many plans have a feature that allows you to automatically increase your contribution percentage every year. Consider setting this in motion so your contribution increases at least 1% each year until you reach 15% or max out the account.
4. You receive more legal protection.
Workplace retirement plans are directed by a federal law called the Employee Retirement Income Security Act of 1974 (ERISA), which offers more security than retirement accounts regulated by states, such as IRAs.
Most notable is stronger protection against lawsuits and bankruptcy. State laws vary, but even keeping IRA rollover funds from a 401(k) or 403(b) separate from a contributory IRA can safeguard them if you get into financial trouble.
The cons:
1. Your money is tied up.
Since the purpose of a retirement account is to help you accumulate a nest egg, there are barriers to tapping funds easily. You’re not allowed to take money out of 401(k) or 403(b) unless your employment ends or you have a hardship, which generally includes:
- Costs to purchase, build, or repair a home
- Unexpected medical bills
- Education expenses for you or a family member
- Funeral expenses
- Payments to prevent home foreclosure
2. You’re subject to early withdrawal fees.
One of the ways you’re penalized for breaking into your workplace retirement account before reaching age 59½ is a hefty 10% early withdrawal fee.
Problem is, even if you qualify for a hardship, the 10% penalty still applies. Plus, you’re subject to income tax on any withdrawal that wasn’t previously taxed.
3. You have limited investment choices.
When compared to other retirement accounts for individuals, such as an IRA, or a regular brokerage account, most workplace plans have a much shorter menu of available investment options.
That means if you want to invest in anything besides basic stock mutual funds, index funds or exchange-traded funds, you may be disappointed. However, the upside is the more traditional diversified funds can reduce your investment risk. Plus, fewer choices may minimize the overall complexity of your portfolio.
4. You must pay account fees.
Workplace retirement plans come with many administrative responsibilities and legal burdens. Therefore, participants are charged fees to pay for these baked-in services.
Overall, the benefits you receive from participating in these plans far outweigh the downsides. However, to keep the cost of your 401(k) or 403(b) as low as possible, check the expense ratios for each investment option and choose low-cost funds.
