401k: How to Reap the Good, Skip the Bad, and Avoid the Ugly

Having a 401k is one of the most common ways to save for a retirement. In fact, in a 2021 study, 68% of Americans working in the private sector offered were 401k or comparable retirement benefits, and 75% of those people chose to contribute. While it may be very popular, there are obvious benefits, and some not-so-obvious draw backs to this retirement strategy.

What is a 401k?

A 401k is a retirement savings plan named after a section in the Internal Revenue Code. The plan is offered by employers, and allows employees to have a percentage of their paycheck go directly into an investment account. Employees typically have options of what they want to invest in (usually pre-defined options provided by the companies) with most of these options being mutual funds.

401k vs 403b

Okay, a quick side note here to clear the air. A 403b is similar to a 401k. A lot of the information presented here will apply to both. In short, a 403b is a retirement plan for nonprofit companies and certain government agencies. This differs from 401ks, which are designated for for-profit companies. I encourage you to read on, but also do some of your own research.

The Good

401ks have a lot of benefits. There is a reason they are so popular among Americans. Tax benefits, contribution limits, employer matches, and average returns are all good reasons to get a 401k.

Tax Benefits: Traditional 401k vs Roth 401k

401ks offer excellent tax benefits. These benefits help you pay less in taxes overall compared to a typical investment account. There are typically two ways to receive tax benefits: while contributing, or while withdrawing. These two methods of taxation break the 401k into two different types: a traditional 401k and a Roth 401k.

Traditional 401k

The traditional 401k offers tax benefits while contributing to your investment account. Your contribution is removed from your paycheck before you are taxed on your income. This means your total taxable income is less, and you pay less in taxes while contributing. However, you will have to pay income tax when you withdraw from your account.

Let’s give an example of this. Assume you make $1000 weekly, contribute 10% to retirement, and are taxed 20%.

With the traditional 401k, you will contribute to the investment account first ($100), and then get taxed on the remainder ($900). This means you would take home 80% of $900, which is $720, or 72% of your paycheck.

Roth 401k

The Roth 401k offers tax advantages while withdrawing from your investment account. Your contribution is removed from your paycheck after you are taxed on your income. This means your total taxable income stays the same while contributing. Come time to withdraw, you now can receive your money tax-free because you already paid your income taxes.

Now let’s assume the same example as before.

With the Roth 401k, you will pay taxes first ($200), then contribute to your investment account ($100). This means you take home $700, or 70% of your paycheck.

Comparing the Two

It may seem like a no-brainer to pick the traditional over the Roth because of the $20 extra. However, don’t forget that when it comes time to withdraw, the balance in the Roth account is truly $700, where the balance in the traditional account is $720 before taxes.

Not all employers offer the Roth 401k option, but if you have the option, I recommend you run some numbers before you dive in. There are plenty of online calculators, but this one is my personal favorite. You can adjust the tax rates as well as contributions, and look at how things stack up with and without contributing the additional savings to retirement. (In our example, the additional contribution would be the $20 so that you take home $700 in both scenarios).

Contribution Limits

401k contributions limits have historically been good, with the maximum for 2022 (at the time I am writing this article) being $20,500 for people under 50, and $27,000 (adding the $6,500 in extra contributions) for people over 50. This is a substantial amount of money to save for later, but how does it compare to what financial advisors recommend?

Typically, financial advisors will recommend you should invest 10-15% into your 401k. In order for the maximum contribution to effect you hitting your 15% contribution, you would have to make over $135k, which is quite a considerable amount of money (for me, at least). This is good news, since you can contribute enough for retirement without worrying whether you will have enough.

I think this goes without saying, but again, calculators are huge in figuring out your potential ‘nest egg’ at retirement. I’ll point back to this one for anyone who missed it above. You can set contribution limits and estimated retirement age to help you plan accordingly.

Employer Match Programs

These are the holy grail of 401k programs. An employer match is a contribution made by your employer into your investment account. The contribution can be a complete match, or a partial match. A complete match means that they will match your contribution dollar for dollar. So if you contribute $100 per week, they contribute $100 per week. A partial match on the other hand, means they will match a potion of what you contribute. So if you contribute $100, they may contribute $50.

Typically employer match programs max out at a certain percentage. It’s rare to see an employer match whatever you contribute, so make sure you read your company contribution limits before you set your own. This means that you can sometimes contribute outside of what your employer matches, which is a completely personal choice.

Here’s a quick look at what a company match could look like.

My company matches 60% of the first 6% I contribute. Assuming I make $1000 per paycheck, I would contribute $60 (6%) and my company would contribute $36 (60% of 6%) for a total contribution of $96 into my 401k. If I were to contribute 2%, then I would contribute $20 and my company would contribute $12 (60% of 2%) for a total contribution of $36. If I were to contribute 10%, then my contribution would be $100 and my company would contribute $36 for a total contribution of $136. Any amount over that first 6% that I contribute, my employer no longer matches.

Average Returns

Average returns can vary for different 401k plans. Depending on the 401k portfolio that you are investing in, the returns could range from 5% to over 14%. As you may have heard before, with higher risk comes higher reward. Conservative portfolios can expect 5-8% average yearly returns, where more aggressive portfolios can expect the 10-12% average returns, with some even reaching 14% on average.

These returns are excellent for someone who plans to continue investing for a long period of time. Investing in retirement accounts takes advantage of compounding, meaning you earn money on your earnings. This is very powerful when you have plenty of time to acquire earnings, and earning 8-10% on those earnings will go a long way fairly quickly.

To see how compounding works, let’s assume you contribute $10k per year to 401k. To start, you have $10k. After a year, you have $21k. That’s the $10k from the start, plus the $10k you invested, plus the $1k of interest. After a second year, you have $33.1k. That’s the existing $21k plus the $10k, plus now $2.1k of interest. Notice how the interest on your investment grew year over year?

Following this same example, after 10 years, your 401k balance would be $185k. That means you made a total of $75k of interest! After 20 years, your balance would be $640k. That means you made a total of $440k on interest! Clearly, the longer your money stays invested, the more it will grow. Not only that, but it will grow at a faster rate. Notice how in the first 10 years you make $75k in interest, but in the second ten years you make an additional $365k? That’s the power of compounding.

Rule of 72

A fast way to calculate how quickly your money will double is by using the rule of 72. To do this, you divide 72 by your interest rate. So if you expect 10% returns on your investments, then it will take 7.2 years (72/10) for your money to double. This of course assumes you don’t invest more along the way.

You can also use this to see how many times an investment will double in a given time. Say you have 40 years and the same conditions as above. Well if you double every 7.2 years, then your money will double about five and a half times (40/7.2=5.56) during that period.

The Bad

While there are some stellar benefits to the 401k, there are also some drawbacks. Some of the biggest drawbacks include set withdrawal periods, early withdrawal penalties, and limited options provided.

Set Withdrawal Periods

A 401k is an investment account for retirement. And like it or not, the tax code has its own idea of when retirement is. For Americans, this is once we are 59 1/2 years old.

Now 59 1/2 might not seem like a big deal, but let’s look at retirement age for a second. When you think about it, there is no rule stating you have to retire at 62, or 65, or 70. Those numbers come from social security.

Social security, in case you didn’t know, is something most employees (and employers) pay into. Essentially, we all pay into social security funds, and then that money is divided up and given to people who are retired and filed to receive money. The age brackets for increased monthly earnings are 62, 65, and 70. That’s why people typically retire around this age.

Retiring in our 60s is something that we assume to be a fact, and the underlying reasoning is because of social security and 401k payout dates. If you want to retire earlier than 60, then it’s going to be tough if all of your money is tied in a 401k.

Early Withdrawal Penalties

So you might read this title and think “but you just said I can’t withdraw until I’m 60”. The truth is, you can withdraw early, but there is a cost. If you withdraw from your 401k early, you’ll be subject to pay 10% penalties to the IRS.

Now there are two different scenarios, so we can break them up.

If you have your money in a Roth 401k, then you already paid income taxes. So early withdrawal will charge you 10% tax. So if you have $1m in your 401k and decide you want all of that money now, then you would have to pay $100k in penalty taxes on that. That leaves you with $900k.

If you have your money in a traditional 401k, you haven’t paid income taxes yet. So early withdrawal will cost you 10% plus the taxes you have to pay on your income. Now assuming the same example as above, taking out all of your money at once would put you in the highest tax bracket of 37%. That means you would pay 47% in total taxes, or $470k. That would only leave you with $530k.

Now these examples are a bit extreme. You might be 50-55 and want to take out little bits. That’s fine. Just know that you will be taxed extra for it.

Limited Options

The last thing I have to say against 401ks are the investment options you have. Because the plan is set up through your employer, they give you a list of plans you can invest in. If you don’t know what you’re doing, then typically larger employers will have decent plans to choose from. I’ve seen company recommended options that diversify your portfolio and can be adjusted for the risk/return level that best suits your needs.

But what if you want more control over where your money goes?

401k vs IRA

Unlike a 401k with investment options provided by your employer, IRAs (Individual Retirement Accounts) give you more freedom in your investments. IRAs come in both traditional and Roth forms, and the tax advantages are the same.

Unlike 401ks however, IRAs have much lower contribution limits. Instead of $20,500, you can only contribute $6,000. This means that you will have a much harder time reaching large sums of money if that’s your goal.

If you want to learn more about IRAs, I recommend you do some research on the IRS website. Here and here are two good places to start.

The Ugly

I think the best way to show you the horrors of 401k plans is with a nice story.

This year (2022 at the time of writing), we have seen a terrible economic downturn. A lot of companies are having bad quarters, and posting profits well below usual.

What does this mean for your 401k? Bad News.

For me, being young definitely has had its perks. I have plenty of years before I can collect from my 401k (over 35) so I can weather the storm. Though my 401k is down over 17% this year, I know that it will be up in the years to come and I have plenty of time to make that money back and then some.

Some of the older people I know won’t be so lucky. Someone I know was about six years out from retirement at the beginning of the year. Now you can imaging the size of their 401k compared to mine. Losing 17% was detrimental to them. I lost maybe $5k, but they lost over $150k. Imagine being so close, and within six months having all that taken from you. They said retirement is now looking like twelve years away.

Moral of the story, six months of a bad economy added six years of working to this person’s life. There are definitely horrors to be had if you aren’t careful.

My Take

What’s my opinion on the 401k? I would say I’m neutral. As someone who wants to retire earlier than 60, I don’t want to have all my money tied up to a point where I’m stuck waiting for my birthday. That being said, you can’t go wrong with tax benefits and company matches. Here’s what works well for me.

Disclaimer: This is NOT financial advice. I am explaining what I do strictly for educational purposes.

Reap the Good

I don’t like the thought of having to pay taxes later. That’s why I invest in a Roth 401k. Sure I take the hit now, but when I’m 60, I have a sweet chunk of change, all tax free.

Also, my company offers 401k matching, so I definitely take advantage of that. In my mind, that’s free money. My company is basically saying “here’s some money, keep up the good work”. Who am I to say ‘no’ to that? My employer matches 60% of the first 6% I contribute. That means that I automatically get a 60% return on my money. Score!

Now my investment strategy does not solely rely on 401k. Because of this, I only invest to get my company match. That means I contribute 6%, and they give me 60% of that, which is 3.6%. So overall, I’m still “contributing” 9.6% to my 401k for retirement, which is just below the 10-15% recommendation of financial advisors.

Skip the Bad

My personal investment strategy does not solely depend on 401k for retirement. That means I can retire before I’m 60 and not have to worry about early withdrawal or anything like that. Essentially, I can skip over the bad aspects.

Also, since I am not relying on 401k, I have less concern for which plan I am in. Now let me clear the air. That does not mean I don’t care where my money is going. But I am not spending countless hours to research and make sure I am maximizing my return in an IRA. Instead, I chose the plan my company recommended for my age, and have seen good results thus far (besides these past six months).

Avoid the Ugly

That story about the person I knew happens more often than you think. A great way to avoid this is to convert your investments into a more stable portfolio. I definitely plan on doing this once I get older. Converting your portfolio from a majority in stocks and ETFs into a majority in bonds easily increases the stability of your portfolio, and it’s usually pretty easy to do.

Now because I won’t be relying on 401k for retirement, I can make this conversion sooner than if I was only relying on 401k. Instead of trying to get every penny, I can be a bit more conservative and switch over knowing I will be financially well off regardless of the economy.

Final Thoughts

There is a lot of information in here. I recommend you take a moment to absorb it, then take a second read through.

There are ‘good, bad, and ugly’ aspects of 401ks. You can get tax advantages and company matches, but you also can get whacked with early withdrawal fees.

In the end, it is up to you to figure out how you want to utilize your 401k. Explore the options, and figure out what is best for you.

If you need some help getting started, I recommend you start here.

Happy Spending!

-The Spendgineer