The traditional 401(k) retirement plan has been around since 1978 and is a vehicle for an individual worker to save for his or her future retirement (saving for retirement is a good thing). The 401(k) has largely replaced company pension plans (a bad thing since individuals are less likely to save if given a choice). The worker contributes a portion of his salary pretax, and the company (sometimes) matches a portion of those contributions. After the age of 59 1/2, the employee may withdraw the money on which he pays income tax. After age 70 1/2, the employee must begin yearly withdrawals. The 401(k) has both pros and some cons:
The 401(k) is an easy way to save for retirement. Retirement is a time when income is reduced or stops entirely. Retirement could last as long as or longer than one’s work life. Think of it like this – the money I make today while I’m working must pay for today and must pay for one day in the distant future.
Any company match is “free money.” Free money is a definite good thing.
Contributions are automatically deducted from salary, and, therefore, the employee can’t spend it. In these times of spend, spend, borrow and spend some more, not having access to money is a good thing.
You don’t pay income tax on the contributions and that increases your take home pay. A $5000 yearly contribution in a 30% tax bracket (both federal and state) is a $1500 tax savings. If, however, you don’t do something wise with this “extra” money, this advantage is lost.
The contributions are intended for your retirement and cannot be withdrawn before age 59 1/2 without a 10% penalty (some exceptions).
All the money is taxed at withdrawal. The money taxed is your original contribution (which remember was not taxed in the year it was earned); the growth and earnings over the years is also taxed. The original idea of taxing the money later in life is that you would be in a lower tax bracket when you withdraw it. Turns out for many people that the tax bracket is the same or higher, and with taxes currently at an all time lows, future withdrawals most probably will be taxed in higher brackets. And at age 70 1/2, the contributor must begin to withdraw the money. A $1M 401(k) balance requires a withdrawal of $36,500 in year one. This additional income might put you in an even higher tax bracket.
All the money is taxed at withdrawal as “income.” Earnings are not taxed in the lower, capital gains tax category.
All three of these “cons” can be negated if you put your contributions in a Roth 401(k), which is available in some plans, or if you instead invest the money in a regular account.
Bottom line: Retirement savings is essential and the 401(k) remains a key component in your financial planning.
Please note that almost all financial decisions have “pros” and “cons.” Many financial planners are, in fact, just salespeople who only talk about the pros. Be careful and ask questions.