Are you wondering if your 401k is a scam? It’s not. But it’s also not the gold standard path to retirement, so many of us are told! There are a lot of pros and some fascinating cons to investing your money in a 401k. Let’s dive in!
What is a 401k?
Let’s get in a time machine and travel back to 1978! Congress has just passed the Revenue Act of 1978. This act was an amendment to the Internal Revenue Code, which allowed for reducing income taxes and widening tax brackets. It also established Flexible Spending Accounts, allowing people to put away money for healthcare costs untaxed. The downside to Flexible Spending Accounts or FSAs is they are “use it or lose it.” This means that any of that untaxed money you don’t spend during the year is forfeit to your employer.
Back to 401ks! The Revenue Act of 1978 added a new section to the Internal Revenue Code. Section 401k. This section gave employees a tax-free way to defer compensation from bonuses or stock options. It wasn’t until two years later that an enterprising benefits consultant named Ted Benna saw the new law for the golden opportunity it was.
He would eventually pave the way for companies using the new 401k provision to create tax-advantaged savings accounts for their employees.
How do 401ks work?
Here are the bullet points for how 401ks work. They are not a scam because they are a legitimate and legal way of saving for retirement. When people call them a scam, they only mean there may be better ways to save for retirement!
- Your employer must opt-in to a 401k program. If they do not, you have plenty of other retirement account options like an IRA.
- If your employer offers it, you may select a percentage of your income and put it into the 401k account tax-free.
- You cannot withdraw the money you put in without a penalty until you are 59 ½ years old. In some circumstances, you can withdraw without a penalty as early as 55.
- You will pay taxes when you withdraw the money.
- The IRS sets a maximum contribution limit on 401ks every year.
- Sometimes, companies will “match” a certain amount of money into your 401k every year.
A hypothetical situation might look like this:
Your job offers a 401k program. They also are willing to match up to 3% of your income. You make $100k per year and decide to contribute 6% of your pre-tax income. That leaves you putting in $6k per year, and your company contributes an additional $3k because of the matching. You contribute $9k, which is well under the $19,500 maximum contribution limit for 2021.
Why your 401k is a scam
Ok, ok, it’s not a scam. But there are quite a few reasons it might not be the best way to save for retirement! Let’s look at a few:
- You cannot touch the money until you are almost 60 years old. This is not only inconvenient, but it’s significantly limiting. This type of investment is not ideal for people looking to retire early, buy a home soon, or want their money to be more liquid if a great opportunity arises!
- You still have to pay taxes when you take it out. A good rule of thumb is If you are earning more now than you plan to be making at 60, a 401k is good. If you are making less now than you plan to be earning at 60, a 401k is a scam. If you are in the second group, consider an IRA instead!
- Fees. This one really can go either way, but it’s well worth your time to read up on the costs involved in your companies 401k program.
- A study showed that companies that offer 401k matching pay less in total compensation.
401ks are an excellent option when considering retirement accounts! They require employer buy-in and have some significant limitations. If you don’t have the patience to learn about other retirement options, go with the 401k! If you have the energy to maximize your money, take a look at IRAs, Roth IRAs, and other investments like real estate! They may serve you better in the long run.
Jon Kuperman is a software engineer and real estate investor. He’s always looking for new investments. He’s also hoping to achieve financial freedom through investing.