401(k) Plan Pluses and Minuses: How Does It Add Up?

Retirement is a long way down the road for many employees-an event that is barely visible on the distant financial horizon. For these individuals, retirement plans may not seem particularly important.

However, the decision over whether you should contribute to a 401(k) plan can have a big impact on your long-term financial future.

These types of retirement plans offer significant advantages to those who choose to participate in them. On the other hand, there are certain disadvantages to these types of savings plans. Your contribution decision should be based on adding up the pluses and minuses, and seeing which comes out on top.

The Positives

Contributions to a 401(k) plan by the employee are made on a pretax basis (although some plans allow for additional contributions on an aftertax basis). Pretax contributions are those that are taken from your salary before income taxes for the year are determined. The result is a lower tax bill in the year that contributions are made.

This doesn't mean that the contributions are tax-free. Instead, you pay taxes when the money is withdrawn from the plan, usually at retirement. In other words, taxes on your contributions and on the earnings (interest, dividends and capital gains) are deferred. However, the money builds up more quickly than would be the case if you invested aftertax money and paid taxes each year on the earnings.

The tax-deferral aspect also gives you flexibility to determine the best time to pay the tax, with the possibility that when you eventually do pay taxes, it will be at a lower rate.

The other major advantage of many 401(k) plans is employer-matched contributions. For instance, an employer may contribute $0.50 for every $1 that you contribute to the plan. This is an obvious advantage-you are earning 50% on your contribution before you have even invested it anywhere.

This advantage depends in part on any cap the employer may have on the match. And the advantage depends on the employer's vesting requirements. Vesting is the right an employee gradually acquires to receive employer-contributed benefits, and is based on the length of time employed. The faster vesting requirements can be met, the more advantageous the employer match, unless you plan to stay with the company (or have been with the company) for the full vesting time period.

There are several other important advantages offered by 401(k) plans:

• Flexibility: You can determine the amount you are able to contribute, and you make the decisions as to where your money is invested among the available investment choices.
• Portability: If you should leave your employer, any contributions you have made to your plan, as well as their earnings, are yours; vested contributions made to your plan by your employer are also yours.
• Periodic investing made easy: An automatic deduction from your paycheck each month allows you to gradually build up your investment without having to make big financial sacrifices.

The Negatives

These advantages are strong arguments in favor of participating in your company's 401(k) plan. But you do need to be aware of the disadvantages.

Limited Access

If you contribute to a 401(k) plan, you will have limited access to your money without costly penalties for a long period of time-until you leave your employer or reach the age of 59½.

If you remain with your employer, access to your 401(k) money isn't entirely restricted, just limited: Some plans allow participants to borrow funds from their 401(k) plan assets, usually at an intermediate-term market rate. However, loans that are not repaid within the restricted time period are considered distributions, with taxes and a 10% early withdrawal penalty due. In addition, some companies will permit withdrawals from a 401(k) plan due to severe financial hardships. However, anyone requesting part or all of their dollars under this clause must show their employers that they have exhausted all other non-retirement financial resources, and the withdrawals are also subject to the 10% early withdrawal penalty and, of course, income taxes.

These features are comforting for short-term emergencies, but you will have lost the primary advantage of the plan. To take full advantage of your employer's 401(k) plan, you should consider money invested in the plan to be long-term savings.

If you leave the company and you have not reached 59½, you can take a lump-sum distribution of your 401(k) plan money to spend as you wish, but only by paying a 10% early withdrawal penalty and, of course, taxes. You can avoid the penalty only by rolling your money over into an IRA or a new employer's qualified plan.

Limited Choices

A second possible drawback is that you are limited to the investment choices provided by the employer. This may or may not be a negative. Most employers provide at least one form of investment in three broad asset categories-cash, bonds, and stocks. And many employers provide a number of choices within those categories. But if you are uncomfortable with or strongly dislike your employer's selection(s), you may want to consider an alternative savings vehicle.

The Decision = Adding It All Up

For most individuals, the positives of contributing to your employer's 401(k) plan will outweigh the negatives. But make sure you do the math to make sure it all adds up.

© 2010 AAII Journal