Essential InSights

Core Topics for the Everyday Investor

Account Types: 401(k)

Account Types: 401(k)

The ‘Standard’ Employee Retirement Plan

Annual Contribution Max: $19,500 or $26,000 if over 50 years old. 

Why we like 401(k) plans:

  • An easy option if you’re an employee
  • Automatic Enrollment
  • Can have Employer matching contributions
  • High contribution limits for employees when compared to a Traditional IRA, Simple IRA or Roth IRA
  • Can be added with other retirement plans like a profit sharing plan enabling for greater contributions
  • Tax-deferred growth 
  • Reduce income tax liability with each dollar contributed
  • Systematic savings
  • Access to loans 
  • Creditor protection when 401(k) qualifies under ERISA
  • It speaks a Common Language, it’s familiar
  • Portability after employment (

Why we don’t like 401(k):

  • Can have limited investment options
  • It may take several years before you fully own your employer’s matching contributions (dependent on vesting schedule with employer)
  • Requires a Fiduciary Standard of Care for the oversight 
  • Can be expensive to set-up, administer, and maintain

You’re likely familiar with this plan and it could be a very convenient retirement plan option for many companies. Companies usually strive to make it easy for employees to set up and for them to manage on their own. Because a 401(k) is a retirement plan offered by most for-profit companies as an employee benefit you will find most people are familiar with the idea and have in the past contributed by diverting part of their paycheck into the retirement plan.

A 401(k) provides the typical tax advantages by reducing your income and deferring the tax liability into your retirement years. For example, if you earn $78,000 in one year and contribute $10,000 to your 401(k), you avoid paying income tax on the portion you contributed. Leaving your taxable income at $68,000 for that year. 

Tax-free growth is the best part of any retirement plan. The money apportioned in your 401(k) grows tax-deferred until you take it out, at which time you’ll pay income tax on the money you take out. As with most other types of retirement plans and accounted for in the InSight-full® financial planning process, you have to be 59½ or older to withdraw money without penalty, and you’re required to start withdrawing money at age 72. 

Another great benefit of a 401(k) plan is that employers that provide them can also make matching contributions when you put money into your plan. You read that right – it’s free money, growing tax free, for many years potentially. Two points of caution: 1) actually this is money you earned, treat it as such and 2) you may only earn the employer-contributed portion over several years of employment in a process called “vesting”. You should consult your plan document for more details. 

Moderate to High contribution limits. An additional attraction, and part of your strategy should be that 401(k) plans often have high contribution limits and no income restrictions (unlike Traditional IRAs and Roth IRAs): you can contribute up to $19,500 in 2020, or $26,000 if you’re 50 or older. An often unknown fact is that the total contribution limit, including both employer and employee contributions, is $57,000 (or $62,000 for over-50s). 

Limited investment choices and high fees. The most clear disadvantage of 401(k) plans for employees is that you usually have a limited number of investment choices within the plan, such as mutual funds or index funds. And that these may carry a fee that comes out of the total return of the investments. 

essential insights

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