For most Americans, 401(k) plans are a wonderful HR benefit provided by employers to encourage saving for retirement.
During normal economic times, many employers facilitate additional savings by “matching” a certain amount of employee contributions. For every $1 the employee contributes, the employer may contribute a certain amount (generally, $.25 to $1+) up to a certain percentage of base pay (say, 5%-6%). According to Nerdwallet, the average employer matches 50% up to 6% of an employee’s base salary.
Essentially, employer contributions represent “free money” and an additional part of the employee’s compensation package.
Not only does this help attract and retain talent (via vesting), employer contributions are a way to ensure employees are taken care of during their retirement years. After all, as pension plans are no longer the norm, employees must bare the burden of planning for their retirement.
However, when companies are strapped for cash, eliminating the 401(k) match is often one of the benefits employers slash to conserve cash.
Is it a good idea to continue investing in your employer-sponsored 401(k) if there’s no match? After all, some employer-sponsored plans are laden with fees and sub-par investment choices.
Let’s explore.
What are the benefits of contributing to an employer-sponsored 401(k)?
There are certainly pros and cons of contributing to an employer-sponsored retirement plan. While the benefits almost certainly outweigh the negatives under most circumstances (especially, if your employer matches), each plan is different. You must understand your 401(k) offerings versus what can be obtained in the open market.
When the “free money” is no longer offered, contributing to a 401(k) may seem a little less enticing. Let’s examine some of the pros and cons as you decide if cutting back on your contributions may be worth considering.
401(K) Investing: The Pros
1. Employer may provide a “match” on employee contributions
For most employees that are contributing to their 401(k), maximizing their total return is key.
An employer match is essentially “free money” that represents an immediate return on investment. For example, if your employer matches your contributions $1 for $1, you achieve an immediate 100% rate of return on your money. If your employer matches $.50 per $1 you contribute, you’ve achieved a “day 1” 50% return on investment.
Even if you could find better investment options outside of your 401(k), you’d likely be hard-pressed to find a suitable fund that would beat the best performing employer option plus the matching.
Achieving the max employer match should be your goal. Once you are getting all of the free money your employer offers, consider opening an IRA where better performing investments can be made.
Even if your employer temporarily suspends matching your contributions, that doesn’t mean they’ll never reinstate the benefit. Often, the suspension of the match is just a short-term measure to maintain liquidity and conserve cash during economic downturns. When business returns, the match will almost certainly be re-implemented.
2. Automatic Investing
Investing in a 401(k) guarantees you’ll be investing in regular intervals.
With automatic payroll deductions, you’ll never see the money in your bank account or be forced to make the disciplined decision to invest for your retirement. Also, you’ll never be tempted to time the market. Instead, your contributions will be invested no matter the state of the market.
An automated investing plan can be especially beneficial during down markets when fear may keep you on the sidelines during the best times to buy. Even if your employer is no longer supplementing your retirement savings, at least you will still be investing in regular intervals.
Remember, “time in the market” is much more important that “timing the market.” Take the guesswork out of when to click “buy” by simply automating in your 401(k).
3. Streamlined Set of Investment Options
Both a pro and a con, a limited set of investment options means your retirement savings won’t be overly complicated.
Instead, you can choose a set of funds or asset mixes included in your employer’s plan. For many, this takes the complexity out of investing, meaning they ultimately “set and forget” their retirement options.
After all, consistency is key in a winning investment strategy.
However, be sure to pick funds that provide the best opportunity for maximizing long-term return. For investors with a 5+ year time horizon, look for broad-based index funds. These funds could be large-cap growth or mimic certain indices (such as the S&P 500).
These funds can offer superior returns when compared to bond funds or target date funds. If your employer no longer provides additional funds for your retirement, picking the best performing funds becomes even more crucial to ensure you will have the money necessary to thrive in retirement.
4. Tax Advantaged Savings
401(k)s generally come in two flavors – Roth and Traditional (pre-tax).
With a Traditional, you’ll receive a tax deduction in the year contributions are made. Your investment will grow tax-deferred. When you reach 59 1/2, you can begin making withdrawals from your account. These distributions will be treated as ordinary income.
Essentially, you’ve replaced your salary with investment income!
Roth 401(k)s have a different tax treatment. Contributions are not tax-deductible. Instead, your investments will grow completely tax-free. When you make withdrawals in retirement (59 1/2), you will not owe any taxes on the gains (which will probably be 95%+ of the portfolio).
For example, if you had $5 million in your nest egg, it’d be safe to assume you could safely withdraw ~$200,000 annually for the rest of your life (i.e. the 4% Rule). If you make withdrawals from your Roth, you would not owe any taxes. Instead, 100% of the balance is yours.
By contrast, if you would have elected to contribute to a Traditional account over your working career, you’d likely owe ~$50,000 in federal income taxes every year. As an added benefit, the Roth allows you the option to withdraw your contributions tax and penalty-free. With a Traditional account, you would incur a 10% early withdrawal penalty (if younger than 59 1/2).
Clearly, deciding whether to invest in a Roth or Traditional account can have real economic impacts on your lifestyle in retirement.
401(k) Investing: The Cons
1. Limited Set of Investment Options
One of the biggest downsides of the 401(k) is the limited number of investment options.
In the open market, there are thousands of funds from which to choose. By contrast, the average 401(k) has 8-12 options. While chances are good that your plan will have an equity fund that has matched or outperformed the overall market, most of the funds will probably not offer the returns of other funds you could buy in the open market.
This is because plan sponsors do not want to be liable for providing investment choices that may be “too much risk” for plan participants. By providing options that have less volatility and risk, the investment choices will more than likely underperform mutual funds that can be purchased in the open market.
2. Your 401(k) Plan May Have High Fees
Fees can be a major drag on total returns.
Most major employers cover a significant portion of the fees charged to provide the plan. However, many of these fees get passed along to the plan participants. Generally, the larger the plan, the lower the fees. This is because the costs are spread over more participants. However, for smaller companies, fees could be fairly significant.
On average, 401(k) plans charge participants a fee ranging from .2% to 5% of the balance. Clearly, .2% of assets is a nominal fee. However, a plan that charges 5% can eat into 50%+ of your total returns (assuming your investment options have at least matched the historical return of the overall market).
If your 401(k) plan charges you a 5% fee, you’re probably better off exploring alternative options for retirement (i.e. IRAs) – especially, if your employer does not match your contributions.
3. Not All Plans Offer the Roth Option
For most savers, the Roth 401(k) is a wonderful option since the vast majority of your portfolio will be comprised of capital gains.
With the Roth option, you’ll pay no taxes on distributions in retirement. This provides access to 100% of your portfolio without tax consequences. By contrast, distributions from a Traditional 401(k) are taxed as ordinary income.
While ~85% of 401(k) plans offer a Roth option, not all plan participants will have this option. For those who want tax-free income in retirement, only having access to a Traditional 401(k) plan may not be optimal.
For these individuals, maxing out a Roth IRA before contributing to their employer-sponsored account may be suitable.
However, if you only have a Traditional 401(k) with an employer match, consider contributing just enough to receive 100% of the free money. Then, with other money you want to save for retirement, think about contributing to a Roth IRA.
4. You May Not Be Able to Take Advantage of Downturns
With a 401(k) plan, your contributions are generally automated. With each paycheck, your employer remits your contributions to the plan custodian. Then, the plan custodian (i.e. Fidelity, Vanguard, etc.) invests the money based on your elections.
Clearly, you have little choice of WHEN your investments are made. For most investors, dollar-cost-averaging is the best choice (i.e. a PRO rather than CON).
However, for those who like to have a little more control of how and when their investments are made, an IRA provides more flexibility. With an IRA, investors can accumulate cash. When the market declines, they can put the cash to work at lower levels.
Potentially, buying in “bulk” at lower levels could provide for outperformance. However, timing the market probably won’t work for most investors. Instead, dollar-cost-averaging via payroll deductions is probably more of a “pro” than “con.”
What if My Employer Eliminates the Match?
Now that we’ve discussed the pros and cons of 401(k) plans, is it worth it to contribute if there is no match?
The answer: It depends. If you can pick funds that outperform your 401(k) offerings then you’re probably better off maxing out an IRA first. An IRA may also be a much better option if your 401(k) charges significant fees (1%+).
Remember, take advantage of any “free money” first. Here’s a good order of operations for your retirement accounts.
- Roth 401(k) – up to the max match. Then, contribute to a Roth IRA in index and mutual funds with a track record of outperforming the S&P 500 and/or that fit your risk tolerance.
- Traditional 401(k) (if the Roth 401(k) is not offered) – up to the max match. Then, contribute to a Roth IRA in index and mutual funds with a track record of outperforming the S&P 500 and/or that fit your risk tolerance.
Consider Seeking Professional Financial Advice
While it is wonderful to gain information online, understanding your personal financial situation and risk tolerance is key to financial planning. Consider sitting down with a financial professional to go over your investment options.
Fee-only financial planners can help you analyze the options in your 401(k). They can help you determine which funds within your employer-sponsored plan will help you reach your goals. Further, they can help you open an IRA and advise if there are any other funds that would perform better than your plan’s options.
Most of all, a financial professional can help teach and guide you on your journey to help you achieve your goals.