7 Pros and Cons of Investing in a 401k Retirement Plan at Work

Money Girl explains 7 major pros and cons of having a 401k through your job, and gives you tips on how to save quickly - so you have plenty of security when you’re ready to kick back and enjoy retirement.

Laura Adams, MBA
6-minute read
Episode #385

A 401k retirement plan is one of the most powerful savings vehicles on the planet. If you’re fortunate enough to work for a company that offers one, it’s an incredibly valuable benefit that you should take advantage of.

But many people ignore their 401k plan at work because they don’t understand how it works, worry about what will happen if they leave the company, or mistakenly believe you must be an investing expert to use it.

In this episode, I’ll explain 7 major pros and cons of using a 401k. You’ll learn some of the lesser-known benefits of the program, and get tips on how to save money quickly - so you'll plenty of security when you’re ready to kick back and enjoy retirement.

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What Is a 401k Retirement Plan?

A 401k is a type of retirement plan offered by employers, and is also available if you’re self-employed. It allows you to contribute a portion of your paycheck, before taxes are taken out, to a variety of investment options such as stock funds, bond funds, and money market funds.

Because you put money from your paycheck into a 401k on a pre-tax basis, making contributions reduces your annual taxable income and the amount of tax you have to pay. You defer paying income tax on contributions and growth in the account until you take withdrawals in the future.

However, there’s another option that’s becoming popular called a Roth 401k. With a Roth, you pay tax on your contributions upfront—but typically don’t have to pay any tax on future withdrawals of contributions or investment earnings.

This is similar to the way taxes work with a Roth IRA; however, a Roth 401k has a major advantage, because there’s no income limit. You see, high earners are disqualified from contributing to a Roth IRA—but that’s never the case with a Roth 401k.

See also: 6 Retirement Accounts You Should Know About, Part 1

How Many Americans Have a 401k Retirement Plan?

According to the Investment Company Institute (ICI), about 52 million workers in the United States participated in a 401k retirement plan in 2012. These accounts hold an estimated $4.4 trillion in assets, which has doubled since 2004.

The ICI’s research showed that 401k balances increase with a participant’s age and the length of time they’ve worked for their employer. For instance, workers in their 60s with 30 years of tenure had a balance of $224,287 at the end of 2012, while workers in their 40s with more than 5 to 10 years of tenure had a balance of $53,060. The average account balance across all age groups was $63,929.

Pros of Investing in a 401k Retirement Plan at Work

When I started my career over a decade ago and heard about my company’s 401k plan for the very first time, I didn’t enroll in it. I was nervous about having investments with an employer, because I didn’t understand what might happen to my money if I left the job, or if the company went out of business.

I want to put your mind at ease about using a 401k, because there are many more advantages than disadvantages to doing so. Here are 4 major pros to consider before investing in a retirement plan at work:

A powerful, but lesser-known 401k benefit is protection from creditors.

401k Pro #1: Federal Legal Protection

Qualified workplace retirement plans are protected by a federal law called the Employee Retirement Income Security Act of 1974 (ERISA). It sets minimum standards for employers that choose to set up retirement plans, and for the administrators who manage them for you.

ERISA was enacted to protect your interests and those of your beneficiaries when you participate in a retirement plan at work. Here are some of the protections you get:

  • Disclosure of important facts about your plan's features and funding 
  • A claims and appeals process to make sure you get your benefits 
  • Right to sue for benefits and breaches of fiduciary duty if the plan is mismanaged 
  • Payment of certain benefits if you lose your job or a plan is terminated

Additionally, a powerful, but lesser-known benefit is protection from creditors. Let’s say you have money in an ERISA-qualified account, but lose your job and can’t pay your car loan. If the car lender gets a judgment against you, they can attempt to collect debt from you in a variety of ways - but not by getting into your 401k.

So never be afraid that an employer could steal your money, or fail to release your funds, if you move on to another job. It’s easy to transfer funds into a 401k with a new employer, or open a rollover IRA that you manage on your own. However, note that there are exceptions when a qualified-ERISA plan is at risk, such as when you owe the IRS for federal tax debts, owe criminal penalties, or owe an ex-spouse under a Qualified Domestic Relations Order.

401k Pro #2: Matching Funds

Many employers that have a 401k retirement plan also offer matching contributions. These additional funds boost your account value. For instance, the company might match 100% of what you contribute, up to 3% of your income.

For instance, if you earn $50,000 per year and contribute 3%, or $1,500, your employer would also contribute $1,500 on your behalf. You’d have $3,000 in total contributions and have received a 100% return on your $1,500 investment. That’s not too shabby!

Free matching funds give you a raise for doing nothing. So always set your 401k contributions to maximize an employer’s match, otherwise you’re leaving easy money on the table.

401k Pro #3: High Contribution Limit

Once you’re contributing enough to a take full advantage of your 401k matching, it’s time to raise your contribution amount each year.

For 2015, the annual allowable 401k contribution limit has been increased to $18,000, or $24,000 if you’re over age 50. While that might seem like a lofty goal if you’re just starting out, you should aim to set aside no less than 10% to 15% of your gross income for retirement.

If you’re a high earner, make sure that your plan will stop taking contributions once you hit the annual limit. If not, you can avoid contributing too much by making flat, equal payments. For example, if you’re paid bi-weekly with 26 pay periods in a year, you could contribute $692.30 ($18,000 / 26) from each paycheck to max out your 401k.

Every time you get a cost-of-living raise, a promotion, or a bonus, you’ll add more to your 401k without even thinking about it.

But if you can’t get near the maximum, contribute a percentage of pay instead. Every time you get a cost-of-living raise, a promotion, or a bonus, you’ll add more to your 401k without even thinking about it.

Most plans also have a feature that allows you to automatically increase your contribution percentage every New Year. Go ahead and set this up to increase 1% each year until you reach 15%. That’s a simple way to make sure you set yourself up for a happy and secure retirement—and you probably wont even miss the money.

401k Pro #4: Free Financial Advice

If your 401k provider offers a free consultation with a financial advisor, take advantage of the opportunity to get customized advice and ask questions about your investment choices.

After you enroll in a 401k retirement plan, you’ll need to choose how to invest your money from a menu of options.

Most plan providers are major brokerages—such as Fidelity, Vanguard, and Merrill Lynch—that have terrific resources, such as an online assessment, to help you figure out the best investments for your situation.

They can recommend a diversified combination of funds based on your age and risk tolerance. In general, the more time you have until retirement, or the higher your risk tolerance, the more stock funds you should own. Likewise, having less time or a low risk tolerance means you should own a higher percentage of bond funds or money market funds.

If your 401k provider offers a free consultation with a financial advisor, take advantage of the opportunity to get customized advice and ask questions about your investment choices.

See also: How to Make Money Investing in Stocks


Cons of Investing in a 401k Retirement Plan at Work

While the advantages of a investing in a 401k retirement plan at work outweigh the disadvantages, here are 3 cons to consider:

401k Con #1: Limited Investment Options

When compared to other retirement accounts (such as an IRA) or a typical taxable brokerage account, you’ll probably find that your 401k has fewer investment options.

That means if you’re looking for exotic investment choices outside of the basic asset classes of stocks, bonds, and cash, you’ll come up short. However, having a limited menu does streamline your investment decision and minimize complexity.

401k Con #2: Account Fees

Due to the administrative responsibilities required by 401k plans, they’re relatively expensive to run. Most plan participants have little control over the quality of services they receive, which influences the fees you ultimately pay.

To keep your account fees as low as possible, choose low-cost index funds or exchange-traded funds (ETFs) when possible.

401k Con #3: Early Withdrawal Fees

One of the inherent disadvantages of putting money in a retirement account is that you’re typically penalized for taking an early withdrawal before reaching age 59½.

In most cases, you can take money out of your 401k only if you have a financial hardship. Even then, you’re required to pay a 10% penalty. This discourages participants from tapping their accounts, and makes it easier to keep your retirement funds growing.

About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlersbook is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.