What are the Benefits of 401(k) Plans?

401(k) plans are powerful tools for retirement planning. But they’re not perfect – the benefits of 401(k)s have come into question even to the point where some people suggest avoiding them altogether.

Before giving up on the 401(k), it’s important to understand the benefits that a 401(k) plan offers. You might ultimately decide that it’s not for you, but at least you’ll know what you’re giving up.

Free Money

One of the most important benefits of a 401(k) is extra help from your employer. The company you work for might “match” contributions that you make to the plan, which means you get more money stashed away for retirement. That “free” money can help you reach your goals and retire more comfortably. If your benefits package includes matching contributions, there are very few good reasons not to save enough to get the company match. Assuming a dollar-for-dollar match, if you save just enough (and no more) to get the company match, you get a 100% return on your investment.

Of course, not all companies match your savings. Instead, they might make profit-sharing contributions regardless of what you do, or they might not make any contribution to the plan at all. In those cases, the 401(k) becomes less attractive, although you might still benefit from some of the features below.

Tax Benefits

401k Piggy Bank401(k) plans also offer tax benefits. Any earnings in your 401(k) account are tax-deferred (or tax-free if you use a Roth 401(k)), so you can reinvest those funds for even more growth without having to deal with taxes. What’s more, the money that you save can go into the plan “before taxes,” which makes it easier to save. If you save $100, you might not notice the full $100 missing from your budget – it might feel like you’re missing only $80. What about the $20 difference? That’s money that you would have paid in taxes (you’ll still have to pay it someday, but you get a break today, which might make it easier to get the company match).

You can also make Roth 401(k) contributions and get your taxes out of the way up front. If you think that you might pay taxes at a higher rate in your retirement years, Roth 401(k) could make sense.

Keep in mind that the same tax benefits are available from a traditional IRA or Roth IRA, but there are some added benefits to using a 401(k). First, you don’t have to qualify: with an IRA, you might not be allowed to take a deduction or even make a contribution (in the case of Roth) if your income is too high. With the 401(k), all you have to do is be eligible to contribute. In addition, you can save more each year in a 401(k) than you can in an IRA, so you can use those tax benefits to a greater degree.

Make Life Easy

401(k) plans make saving for retirement little bit easier than it would be if you did everything on your own. Everything is set up by your employer, and you just need to enroll (of course, your employer might not do a great job of setting things up, choosing investments, or managing fees, but many companies do just fine). Money moves directly from your paycheck to the 401(k), and you typically don’t have to meet any minimum purchase requirements.

A Safe Place

Once your money is in a 401(k) plan, it’s in a safe place. Retirement accounts such as 401(k)s and IRAs benefit from creditor protection in most states. It is extremely difficult for anybody to force you to spend that money – even if you owe them money and they win a lawsuit against you (although in some cases, such as when you’ve committed fraud, you’re out of luck no matter what).

Your 401(k) savings are off-limits even to your employer. If the company you work for falls on hard times, your money is your money – it’s in a trust and can only be used for your benefit. Of course, if you invest in your company’s stock you can indirectly lose money as your company stock goes down, but hopefully you’ll diversify your money (spread it out into lots of different investments).

Safety Valves

401(k) plans are for your retirement money, but sometimes things don’t go as planned. With some 401(k)s, there are ways to get cash out early. You can always cash out after you leave your job, but what if you need cash and you want to keep your job? Some plans allow you to borrow against the money in your account, and there are no tax consequences as long as you repay the loan (there are risks and drawbacks of taking loans though). Other plans allow you to simply withdraw money, but you might have to pay taxes and tax penalties if you do that.

Ideally, your retirement savings will stay in your 401(k) until you actually retire. But some companies allow you to access that money if you ever need it.

Is It Perfect?

No. There are a lot of good reasons for using a 401(k) plan. However, you need to understand the limitations. First, not all 401(k)s are created equally – in fact some of them are pretty cruddy, featuring high fees and a poor selection of invesetments. In addition, your retirement security is entirely up to you when you use a 401(k) plan. However, it might be all you’ve got. Whether you use your company’s 401(k) plan or not, you’ll have to develop a plan and save for retirement somewhere.