14 Pros and Cons of 401(k) Plans for Beginners

Having a hard time deciding whether or not a 401(k) is worth it? Or whether you should contribute more or less from your paychecks? Weighing the pros and cons of 401(k) plans?

I remember signing up for my first 401(k) and having no idea what it was or why I was doing it. Some person from HR told me I should sign up for it because it was for my retirement. I was ill-informed on how it actually worked and what were the benefits and limitations.

To answer these questions, we will explore the pros and cons of 401(k) plans for beginners. It may sound overwhelming at first, but after reading these 14 pros and cons, you’ll be a 401(k) master!

First, What is a 401(k)?

Before going over what is good and bad about a 401(k) plan, what is a 401(k)?

A 401(k) is a retirement plan that is provided by your employer.

And in case you are wondering, if you work for a non-profit or government entity, you’ll instead have a 403(b). Same thing, different numbers and letters.

I don’t want to spoil the list of pros and cons here by describing what a 401(k) is, but a 401(k) behaves similarly to any other Individual Retirement Account (IRA) where you take money and invest it into funds in the Stock Market.

The difference between a 401(k) and a Traditional IRA is that your employer will automatically deposit your allocated amount before taxes come out.

401(k) plans make it simple and easy for people to start building that retirement nest egg.

Pros of 401(k) Plans

With a basic understanding of a 401(k), we’ll start by discussing the pros and why a 401(k) plan is worth it.

1. Tax Advantages — Keep More of Your Money!

The first pro of a 401(k) plan is the tax advantage.

Nobody likes paying taxes, right?

How do we not pay taxes then?

The benefit for a 401(k) is also referred to as “tax deferred”. Simply put, you are choosing to not pay taxes right now but will pay them later. Later as in, retirement.

Let’s use an example to see how this works.

Suppose an individual earns an annual salary of $55,000 and decides to contribute $5,000 to their 401(k) account every year. By doing so, their taxable income is reduced to $50,000, as the tax obligation on the contributed amount is delayed until the time of retirement.

You just reduced how much tax you owe at the end of the current year. This not only lowers the immediate tax liability but also allows for potential growth and compounding of the invested funds over time.

Initiating a 401(k) early in one’s career can have a profound impact. By investing early, it gives that account more time to grow and compound, as well as keeping more of your own money (rather than giving to the government) to be able to spend, save, or grow wealth.

2. Employer Matching – Free Money!

The second pro of a 401(k), probably more important than the tax advantages, is Employer Matching.

What is employer matching? It’s free money! Most employers will say “If you put 3% of your paycheck into your 401(k) retirement plan, we will also put in 3%.” If that ends up being $100 per paycheck, then your employer will put in an additional $100.

This is a great way to speed up your portfolio growth. Employer matching practically doubles your investment contribution. You can’t say no to that. You can’t find those kinds of returns anywhere.

The KEY in employer matching on 401(k) plans is to make sure you maximize the 401(k) match. You don’t want to leave money on the table. If your employer offers 2%, you need to at minimum put in 2%. If they offer a 3% match, put in 3%. It’s totally worth it. Again, free money!

Also, every company will be different. One company may be straightforward and say “We’ll match up to 3%.” If you put 1%, they’ll do 1%. You do 3%, they’ll do 3%. However, sometimes a company can be tricky about how they match. A company will say “We’ll match 50% up to 3%.” While it sounds confusing, what they’re saying is “If you put 1%, we’ll match 0.5%.” They will match half of what you put in. Therefore, to match up to the full 3%, you will need to put in 6%. Half of 6% is 3%, and that’s when they’ll stop matching.

In that above scenario, the half up to 3%, it’s practically the same as putting 9% of your paycheck into your 401(k) while only putting 6% of your own money.

Employer matching is free money! Do not underestimate this.

3. Automatic Payroll Deduction – Investing on Cruise Control

Automation makes life so much easier. There are countless examples of how automation saved time and money throughout history: when Henry Ford created the assembly line, robotics, supply chains, manufacturing, and even down to our Smart Homes (I love being able to yell at Alexa to set timers and turn on and off lights.)

Automation also helps you NOT forget things. Like investing.

When you sign up for a 401(k) plan, how inefficient would it be if your employer gave you a separate check that you would need to deposit into your 401(k) account on your own? If I had to guess, that money would rarely make it to that 401(k).

Instead, your employer makes it SUPER simple for you and automatically deducts your 401(k) contribution from your paycheck. It’s like it was never there to begin with.

This automation ensures that you are continuously adding towards retirement, whether you’re thinking about it or not.

4. Easy Investing Options – Having too Many Choices Can Cause Paralysis

Not everyone loves investing as much as you and I (I’m assuming you love investing because you’re reading this.) Or maybe they love the idea of investing, but dread the thought of deciding where they should allocate their investments.

Worry not.

401(k) plans have a smaller selection of investment options. Rather than having every single individual stock available to invest in, they limit the selections to certain ETFs (exchange-traded funds). Some of these ETFs include:

• S&P Index Fund
• Large-Cap Funds
• Mid-Cap Funds
• Small-Cap Funds
• Real Estate Funds
• International Market Funds
• Healthcare Funds

But wait, there’s more!

Most ETFs are stock/equity-based, and sometimes people want to invest in Bonds to reduce the risk that comes with stocks. 401(k) plans also offer Bond-based funds.

And if this seems like a lot, and you don’t want to deal with Stocks, Bonds, ETFs, etc. most 401(k) plans offer Target Date funds. Target Date funds are blends of Stocks and Bonds based on when you plan on retiring. The theory is, your asset class allocation (fancy term for what % of your portfolio is in Stocks, Bonds, etc.) will vary depending on how close you are to retiring. The closer to retirement, the higher your Bond allocation should be. If you select a Target Date fund of 2045, that funds allocation will adjust over time the closer you get to that target date.

While this seems like a lot, it’s not when compared to the alternative. The alternative is picking individual stocks. Do you really want to sift through all 500 companies in the S&P 500?

5. 401k Rollovers – It’s Your Money, It Will Move with You

A logical question around 401(k) plans is, what if you switch employers? Then you’ll need to open a new 401(k) and now you have to manage two? Or three? Or more?

Rarely does an employee stick with the same company for their entire career. Luckily, there are options available when it comes to old 401(k)s.

Introducing, 401(k) Rollovers. A 401(k) Rollover is when you take an old 401(k) plan, and move those funds over to a new plan.

Remember that 401(k) plans are unique individual retirement plans with special tax benefits, they need to be handled differently than a normal checking/savings account. When rolling over an old 401(k), it needs to be rolled over to another eligible account, also known as, a tax-advantaged retirement account.

The three main options available for moving an old 401(k) would be:

• Withdrawal or cash-out account
  • Probably not the best idea due to penalties and fees.
• Transfer to new employer’s 401(k)
• Transfer to an IRA (Individual Retirement Account)

Except for cashing out your old 401(k), the other options of rolling over are quite painless.

6. Bankruptcy Protection – You Won’t Lose Everything!

Probably not a well-known pro of 401(k)s, but 401(k) retirement accounts are protected from bankruptcy.

Assets can be classified as “protected” and “unprotected”.

A couple of examples of protected assets are:

• 401(k)s
• 403(b)s
• Roth IRAs
• SEP IRAs
• Simple IRAs

While I am not a bankruptcy expert or lawyer, I hope to never have to declare bankruptcy. However, it’s still nice to know that if that ever happens, those funds you’ve accumulated over many years of your career will be safe.

For more information on this topic, read this article on Is Your 401(k) or IRA Protected in Bankruptcy.

7. Special Scenarios Allow for Early Withdrawals

Might be jumping the gun on one of the cons within the pros section, but since 401(k) plans are meant for retirement, there is a requirement that you are unable to withdraw funds until age 59 1/2. If you do take money out early, you will be subject to paying extra tax. However, there are exceptions to this rule.

Most of these exceptions are rather extreme, and won’t pertain to your average Joe. Some of these include:

• Death
  • A beneficiary is allowed to withdraw from a 401(k) if the owner has deceased.
• Disability
  • If the owner of the fund becomes disabled, they are eligible to withdraw.
• Hardship Withdrawal
  • This is when you are allowed to withdraw under circumstances that are “an immediate and heavy financial need.”
  • Can be used for:
    • Medical Bills
    • Avoid foreclosure/eviction
    • Funeral Costs
    • Costs related to home repairs

As you can probably see, you’re not going to be able to use your 401(k) money early to go on trips and vacations. However, in extreme circumstances, there is some leeway.

This can be a complicated topic, so to learn more, I recommend reading this article on 401(k) Withdrawals or going right to the IRS website.

Cons of 401k Plans

Like a coin, there are always two sides to every story.

401(k) plans are a great way to build a foundation for retirement, and as we discussed above, the pros incentivize people to use this type of retirement account. However, to be incentivized to use this account, there must be some drawbacks.

Let’s look at 7 cons of 401(k) plans.

1. 401(k) Contribution Limits – The IRS Puts a Cap on 401(k)s

You can’t dump 100% of your paycheck into your 401(k).

The IRS sets annual contribution limits for 401(k)s and IRAs.

In 2023, the annual 401(k) contribution limit is set at $22,500. This is an increase from 2022 when the contribution limit was $20,500. There’s also another contribution limit called “catch-up” where if you are over 50 years old, you can contribute up to $30,000. This helps those who didn’t start investing early enough, to contribute more before retirement.

Therefore, if you think you’re going to dump a bunch of your paycheck into this account, you’ll have to temper your expectations. Seems as though the government doesn’t want you to take too much advantage of them.

To read more about contribution limits and the change from 2022 to 2023, read this article released by the IRA on Limit Increases.

2. Limited Investment Choices – But I Want More!

In the pros section, I mentioned that 401(k) plans made it easy for people to invest because of the limited number of options available to them. While a smaller selection may appeal to some, there is probably a group of people who feel this is too limited. They want more options.

What if you wanted to invest in Microsoft or Apple? If you were a savvy enough investor, you could just then put all your 401(k) contributions into a “Large-Cap” fund. But what if that option wasn’t available?

The Target Date funds are interesting when you break them down into what’s in them. I looked up the asset allocation of a 2055 Fidelity Freedom Blend fund. Below is their allocation %:

• 50% – U.S. Equities
• 42% – Non-U.S. Equities
• 11% Bonds
• -3% Short-Term/Net Assets

If you do not plan on retiring until 2055 (30+ years from now) I would prefer to be 100% in equities/stocks. While Bonds are safe, their returns are lower compared to the overall market. Also, what if you wanted to invest only in U.S.-based companies?

Essentially, you lose flexibility in choosing your investments.

3. Early Withdrawal Penalties – You’ll Need to Wait till You’re 59 1/2 Years Old

One of the pros of a 401(k) is that you don’t have to pay taxes until later. Conversely, this means there will be an Early Withdrawal Penalty if you do take the money out early.

This is one reason people don’t like using a 401(k). The liquidity, the ability to use the money whenever you want, is not there. If you put in $10,000 when you are 25 years old, you’ll need to wait 34 1/2 years till you can access that money. You are able to withdraw from your 401(k) penalty-free at age 59 1/2.

On the bright side, not being able to access these funds is good, it forces you to save and invest for retirement.

However, you can withdraw this money early…at a cost. If you withdraw money from your 401(k) before you turn 59 1/2, you’ll be assessed a 10% tax early distribution penalty.

To learn more about this penalty and how it’s calculated, read this article on How to Calculate Early Withdraw Penalties.

Being taxed extra is never a good thing. If you can avoid dipping into these funds, the better.

4. Required Minimum Distributions – Forced to Withdraw, After Being Told Not To…

One thing the average 401(k) holder may not know, is that when you reach 72 years old, the government requires you to withdraw a certain amount of money from your 401(k) account.

At first, this sounds like an odd requirement.

It’s my money, shouldn’t I take out as much or as little as I need?

So why does this requirement exist?

Because the government wants to collect the taxes you’ve avoided paying. If you’ve been contributing to a 401(k) since your early 20s, you’ve had almost 50 years of contributing, investing, gaining, etc. It’s gone in tax-free. That tax has to come due at some point.

An important aspect of investing…you only owe taxes on capital gains IF and WHEN you sell. You’re been told not to use this money until 59 1/2 years old, and depending on other investments you might’ve made, you may not need your 401(k) immediately. With the government wanting to collect, you are forced to start withdrawing a portion of your 401(k).

How much do you have to withdraw from my 401(k) after age 72?

If we’re required to pull out a minimum amount of distributions from our 401(k) after age 72, how much is that exactly?

Well, there is a way to calculate your required minimum distribution, using the IRS “Required minimum distribution tables”. These are updated each year, so make sure you’re looking at the correct RMD year.

The way the calculation works is the first year (age 72) you take the balance of your 401(k) and divide by 25.6. After that, you will continue this every year, however, that 25.6 number will decrease each year until you get to 1.9 (age 115).

For example: if you have a balance of $1 million, and at age 72 you divide that number by 25.6 to get $39,062. That is the minimum required amount you need to withdraw. The next year (age 73) your balance is $960,938, which you’ll divide by 24.7 to get $38,904. And so on…

For more questions, I would refer you to see a tax or retirement expert and review the IRS website on Required Minimum Distributions.

5. Admin Fees

Nothing in life is free. Apparently the same goes for 401(k) plans.

There are 2 types of fees that 401(k) holders should be aware of:

• Admin Fees
  • There are processing/admin fees applied when you contribute to your 401(k). These fees are generally low, 0.5% to 2% depending on your employer.
• Expense Fees on Funds
  • Like with most Index Fund or ETFs, there are Expense Ratio fees tied to them. And since nearly all investment options in a 401(k) are funds, you will be paying these fees. Whichever fund you select to invest in, check the fees. Some are smaller or larger than others.

Sadly, there is nothing you can do about these fees. Hence why this is a con. However, these are small fees in the grand scheme of things.

6. Vesting – You Don’t Own it All Yet…

While employer matching is by far one of the best parts of a 401(k) plan, there is some fine print.

Some, but not all, companies will set a “vesting” period on their employees. Vesting refers to the matching contributions from your employer.

Meaning, that the employee doesn’t own all 100% of their 401(k) for a certain amount of years. An employee owns their personal contributions, but if you were to quit or leave your job prior to that vesting period, you would forfeit either a portion or all of that employer matching.

The conventional theory behind this is that a company is trying to keep its employees around longer.

There’s really not much you can do about this as an employee, but is something to consider when you are thinking about leaving a company.

7. Limited Controls – Employer Sets the Rules

For those with control issues, this may raise some hairs on the back of your neck.

After reading through all the pros and cons, you’ve probably guessed by now, but you don’t have that much control over your 401(k).

This is what you can control:

• How much you contribute (to an annual limit)
• What limited funds you can invest into

That’s it.

What you can’t control:

• Fees
• Which broker you use (Fidelity, Prudential, etc.)
• Which funds are available (No individual stocks)
• When you’re allowed to withdraw.
• How much you’re required to withdraw.
• Total amount of employer matching
• How long till you’re fully vested.

As you can see, there are few things you have control over. And this might be hard for certain investors. If you want to invest with the ability to buy individual stocks, have access to more liquidity, and utilize different strategies (growth, dividends, value, etc.) maybe you should explore other alternatives.

Summary

As with everything in life, there are positives and negatives. Reviewing this list of 14 pros and cons of 401(k) plans for beginners should help educate everyone enough to make their own decisions.

My personal belief (not financial advice) is that I can’t say no to free money. When your employer offers to match a certain %, you can’t pass on a chance to double your money. At a minimum, I always put in enough to match the maximum percentage my employer will offer.

The rest of the stuff that relates to 401(k) is out of your control. Worry about what you can control and move on.

What next? Learn More About Other IRAs

Do you want more control? You should look into different IRAs. Just because you invest in a 401(k), doesn’t mean you’re not allowed to invest in other IRA brokerage accounts.

To learn more about what other IRAs are available to you, read this article on Types of IRAs and their Benefits.

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Thanks for reading! And while you’re thinking about contributing to a 401(k) plan, read my article 7 Reasons Why You Need an Emergency Fund and start contributing to an Emergency Fund as well!

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Disclaimer

Levelzeroinvestor.com is not a registered investment, legal or tax advisor or a broker/dealer. All investments / financial opinions expressed by Levelzeroinvestor.com are from the personal research and experience of the owner of the site and are intended as educational material. Although best efforts are made to ensure that all information is accurate and up to date, occasionally unintended errors and misprints may occur.