401(k) Plan Pros and Cons

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on January 11, 2021

What are the Pros and Cons of a 401(k) Plan?

401(k) plans are the most common type of retirement savings plan in the private sector. 

They allow employees to save for their retirement on a tax-deferred basis and also count as an asset on the employer’s balance sheet. 

But while these plans have many advantages, they also do have some drawbacks that prospective employers and participants should know about. 

Here is a list of the pros and cons of 401(k) plans.

Advantages of 401(k) Plans

  • Traditional 401(k) plans allow plan participants to defer a portion of their earnings on a pretax basis and defer taxation on plan distributions until retirement
  • Roth 401(k) plans allow participants to make after-tax contributions and take tax-free distributions until retirement
  • Plan participants can receive matching employer contributions that increase their plan balances over time and boost the rate of return that they get on their money
  • The money that is held inside a 401(k) plan is now exempt from seizure by creditors
  • 401(k) plans are portable. Employees can now roll their 401(k) plan from a previous employer into the 401(k) plan offered by their new employer, provided that the new plan accepts rollovers (which most do). Employees can also roll their plan into an IRA without incurring taxes. 
  • Employees can often buy shares of company stock inside their 401(k) plans. Many employers also match their employees’ contributions with shares of company stock instead of cash
  • When an employee retires, he or she can spin off all of the shares of company stock from the rest of their plan and sell them in a single special transaction that qualifies for capital gains treatment. This is done under the Net Unrealized Appreciation Rule (NUA)
  • Many employers offer a broad range of investments to choose from inside their plans, including stocks, bonds, mutual funds, annuities, guaranteed investment contracts and money market funds. 
  • 401(k) plans are listed as an asset on the employer’s balance sheet
  • 401(k) plans can serve as a tool to attract and retain quality employees, especially if the plan has a vesting schedule (see below)
  • Some 401(k) plans allow employees to take out a loan against their 401(k) balance up to a certain amount, such the lesser of 50% of the current plan balance or $50,000
  • 401(k) plans must be administered by a plan fiduciary, which means that the administrator must be careful to provide unbiased, high-quality service and administration of the plan

Disadvantages of 401(k) Plans

  • Plan administration can be expensive for employers, especially for smaller plans
  • Many plans charge participants an assortment of fees and expenses, such as administrative expenses that are levied on an annual basis. 
  • Many investment choices, such as mutual funds and annuities, may also charge additional investment management fees that are levied on a monthly, quarterly or annual basis
  • Many variable annuities that are found in a large percentage of 401(k) plans can charge annual fees as high as 2-3%, after factoring in additional fees charged by the annuity on top of any plan fees
  • Any distribution taken from a 401(k) plan is taxed as ordinary income, which means that it will be taxed at the participant’s top marginal tax rate
  • Any distribution that is taken before the participant is 59 ½ years old will be assessed a 10% early withdrawal penalty, unless a qualified exception applies
  • The investment choices inside a 401(k) plan are always preselected, so there is a limit on what a participant can invest their money in (although this is changing, as many plans now allow participants internal access to a full-service brokerage account)
  • Any unpaid loan amount from a 401(k) plan that is not repaid within 90 days of the employee leaving the company will be automatically coded as a regular distribution, with tax and possibly an early withdrawal penalty applying

401(k) Plan Management FAQs

A 401(k) plan is a retirement plan offered by an employer designed to help employees save for retirement.
401(k) plans are employer sponsored, which often provides greater security in exchange for personalization. 401(k)s also only tax on withdrawal, which can be a pro or con depending on your tax bracket.
With a Roth 401(k), taxes are paid as money is put into the retirement account. With a traditional 401(k), taxes are paid as money is taken out.
Alternatives to 401(k) plans include traditional IRAs, Roth IRAs, pension plans (if your employer offers one), and 403(b) retirement plans for employees of non-profit organizations.

What is a 401(k) Plan?

A 401(k) is an account offered by an employer designed to help employees save funds for retirement.

It differs from a savings account or an IRA (Individual Retirement Account) in that it offers a set of investment opportunities that your employer selects.

These can be in the form of stock and bond mutual funds, guaranteed investment contracts (GICs), target-date funds, and your employer’s own stock.

With this plan, you can regularly contribute a portion of your income, usually monthly, to buying investments within the 401(k) that go into the account and become available at retirement.

Depending on the type of 401(k) plan you choose to take advantage of, you will either be taxed when you contribute to your 401(k) or when you pull money out.

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k).

Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s.

The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978.

With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn.

Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006.

Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free.

Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings.

Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer.

Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion.

If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade.

If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion.

To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn.

With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them.

Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire.

If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term.

You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket.

On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true.

In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up.

Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change.

A smart move may be to hedge your bets and divide your contributions between the two types of IRAs.

If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each.

In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other.

When you do decide which avenue to take, make sure to thoroughly evaluate your decision.

Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible.

Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky.

You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company.

If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement.

There is typically no option to grow this amount, but it also does not require any financial investment from the employee.

Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer.

401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute To My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k).

There are limits on how much you can contribute to it that are outlined in detail below.

There are two methods of contributing funds to your 401(k).

The main way of adding new funds to your account is to contribute a portion of your own income directly.

This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)).

The system mandates that the majority of direct financial contributions will come from your own pocket.

It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return.

The second method comes from deposits that an employer matches.

Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee.

However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan.

This is especially important to keep in mind if you want to utilize both types of plans.

A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year.

For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000.

If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions.

The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

401(k) Plan FAQs