Is a 401(k) Worth It?

Sidestep these 7 issues to make the most of your account

Reviewed by Anthony Battle
Fact checked by Vikki Velasquez

Over the past quarter of a century, the 401(k) plan has evolved into the dominant retirement savings vehicle for most U.S. employees.

While many improvements have been made to the structure and features of 401(k) plans since their creation, they’re not perfect. But there are ways to mitigate the impact of these problems, making 401(k)s ultimately worth your time and money.

Here’s a look at seven issues that you may have to face with your 401(k) plan, as well as ways to temper their effects.

Key Takeaways

• A 401(k) plan turns long-term savings for retirement into a habit for American workers.
• A 401(k) can postpone the taxes due on some earnings for decades.
• Some employers match part of employee savings, effectively a bonus.
• Administrative and record-keeping costs can be high.
• Investing options can be limited.

Dollar-Cost Averaging

At its heart, the 401(k) plan maximizes a common investment strategy known as dollar-cost averaging. That is, an investor deposits a certain amount of money every month in an investment such as a stock or a mutual fund. Depending on the vagaries of the markets, that set amount buys more or fewer shares from month to month.

In the end, proponents say, the investor’s price per share averages out at a lower level than a more active strategy would have yielded. The total return is better.

Those less enthusiastic about dollar-cost averaging say it’s simply a convenient justification for the 401(k) system that channels money from your paycheck to the investment funds in your plan. Your funds may be fully valued or even overvalued at the time the contributions are made.

If this is a concern, you’re best option might be to put your contributions into a conservative investment option offered in your plan. The share price should be relatively steady from month to month. Eventually, you might transfer some of the gains into a more aggressive fund for better growth.

It’s up to you to determine when the switch looks attractive from an investment standpoint.

Long Investment Time Horizon

Your 401(k) plan is supposed to provide you with a long-term savings plan for retirement. Given this premise, you may believe that you should develop a long-term strategic asset allocation based on a time horizon of a decade or several decades.

Unfortunately, it’s highly unlikely that the portfolio managers who are currently managing the mutual funds available through your plan will be managing them 10 or more years from now.

That means you could be better off bypassing actively managed funds and choosing index funds for your 401(k). This will remove any mismatch between the short-term tenure of fund managers and your long-term investment holding period.

Actively Managed Funds vs. Index Funds

Most active mutual funds do not outperform their index or benchmark, and they come with higher fees. You are better off putting your money into an index fund. A 1% saving can mean tens of thousands of extra dollars at retirement.

Your fund may not offer index funds as an option. That’s up to your employer.

If index funds aren’t offered in your 401(k) plan, consider developing a tactical asset allocation contingency plan in the event that one of your portfolio managers relinquishes responsibility.

Or, you could consider putting some of your savings into a traditional IRA or Roth IRA instead of your 401(k). You can contribute to both up to the maximum annual combined limit.

401(k) Fees

Your returns from your 401(k) plan are reduced by the fees you will be paying, and they include charges unique to 401(k) plans.

A 401(k) plan is government-approved because it affects your taxes, and that means your company has to take on many compliance issues as well as administrative tasks, employee education, and communication services.

You’re probably paying your share of these costs through charges such as:

• Participant fees
• Supplemental asset-based charges
• Itemized costs for services such as loans, hardship withdrawals, and qualified domestic relations orders
• Higher fund expenses

Costs are particularly steep for smaller employers and plans where a lack of economies of scale fosters higher expenses.

How to Offset Expenses

First and foremost, you should always invest in your 401(k) plan up to the point where you receive 100% of your employer’s matching contribution. Not all employers offer this match, but many do.

Then, you could open a traditional IRA or a Roth IRA and contribute up to your combined annual maximum. This will get you an enormous range of investing options and lower fees than your company 401(k) can offer.

One warning, though—if you or your spouse is covered by an employer-sponsored retirement plan, and your income exceeds certain levels, you may not be able to deduct your entire contribution.

Lackluster Recordkeeping

Recordkeeping for assets in your 401(k) plan is complex and time-consuming, even with today’s technology. Therefore, few retirement plan providers distribute investor-friendly statements. Instead, they generate only what the law requires, which is not sufficient for you to make a useful financial assessment of your investment strategy.

To successfully plan for retirement, you need to know on a monthly basis your beginning account balance, how much you and your employer contributed, the number of transfers or withdrawals you made, the amount of any gains or losses, and your ending balance.

Unfortunately, your record-keeper probably doesn’t provide this information in a user-friendly way. To get the data, you may have to extract the information from your monthly or quarterly statements and build a spreadsheet to track the details.

Know Your Rate of Return

Once you have properly compiled the information, you should manually calculate your annualized rate of return. It’s worthwhile seeking outside advice to get an accurate view of how your investments are performing.

“Often, it is difficult to go through your quarterly statement and decipher how well your investment strategy is working,” says Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, FL.

“By consulting with an outside fee-only advisor,” Dias adds, “you can see how your 401(k) investments are really performing and what modifications can be made without having to transfer to an IRA.”

Important

Most active mutual funds, on which 401(k) plans are based, don’t outperform their index or benchmark. You’re better off putting your money into an index fund.

Limited Investment Options

The conventional wisdom in the 401(k) plan investment industry is that “less is more.” A retirement plan will offer investment options that cover roughly five asset class categories. These categories, in order of theoretical risk, are as follows:

• Money-market funds or stable value funds
• Core bond funds
• Large-capitalization funds
• Small-capitalization funds
• International funds

The concept behind “less is more” is to minimize the complexity of your investment choices. You can develop a diversified portfolio by investing in funds that fall into these five asset-class categories.

That may do it for many investors. If you’re more aware of the variety of investment choices out there, you might want access to Treasury Inflation-Protected Securities (TIPS) funds, high-yield funds, real estate investment trust (REIT) funds, mid-capitalization equity funds, emerging markets funds, and commodity funds to build a comprehensive portfolio for your long-term financial needs.

Widening Your Choices

“When I find a client’s 401(k) has limited (or subpar) investment choices, I always look to see if they have a self-directed brokerage window available to them,” says Carol Berger, a retired CFP® in Peachtree City, GA.

“This allows them to open an account on the ‘brokerage window’ side and opens up many more investment choices,” Berger adds. “The client then has their regular contributions go into this account versus the ‘regular’ 401(k) choices.”

The quality of the investment options offered in your plan may be well below average, particularly if you are a participant in a small retirement plan.

As with any investment, you should conduct a thorough due diligence analysis before making any type of investment. If you’re dissatisfied with your choices, you can contact your human resources department to request changes.

In addition, you could offset any 401(k) plan deficiencies by investing in index funds through an individual IRA.

Advisor Insight

Kirk Chisholm, Wealth Manager at Innovative Advisory Group, Lexington, MA

One frequently overlooked option for an investor who has a poor selection of fund choices is to speak to your employer.

Frequently, employers are not deliberately trying to provide you with poor choices. Many times they are given these choices by the advisor on the plan.

If you request different or additional options, it is possible your employer will say yes. Many employers are looking for this type of feedback.

Tax Implications

The most highly touted 401(k) plan attribute is the pre-tax treatment of invested cash flows. In a traditional plan, the money you pay in is not taxed. It doesn’t count towards your income that year. You won’t pay the taxes due until years down the road after you retire.

However, that money will be taxed at your personal income tax rate, not at the (usually lower) capital gains rate. (This is not relevant to Roth accounts, for which taxes are pre-paid.)

This tax treatment may compare unfavorably to the capital gains taxes you would have owed on investments outside the 401(k) system.

A true comparison is nearly impossible because your tax status will change over time, and the tax laws may well change too. Just bear in mind that what looks like a good deal today may very well be a bad deal tomorrow.

Investment Risk

The 401(k) plan has largely replaced the employee pension plan in the American workplace. In government-speak, the 401(k) plan is a defined contribution pension plan and a pension is a defined benefit plan.

That means that you, not your employer, bear all of the investment risk.

The amount that’s in the fund when you retire is what you will receive as a pension. The fund may lose all (or a substantial part) of its value in the markets just as you’re ready to start taking distributions.

While that’s true of any financial investment, the risk is compounded by the relative inaccessibility of 401(k) money throughout your working years.

“The final problem is that your 401(k) assets are not liquid,” says Dan Stewart, CFA®, president of Revere Asset Management, Inc. in Dallas, TX. “Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement. Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary.”

What Are the Advantages of a 401(k)?

A 401(k) has many advantages as a long-term savings vehicle.

• The contributions are made on a pre-tax basis, lowering your yearly taxable income.
• Your employer may match a portion of your contributions, increasing your savings.
• They are a relatively easy, steady way to compile a stash of cash for your future.
• 401(k)s are protected from most creditors.

Is It Better to Have a 401(k) or an IRA?

Many investors choose to have both as they each offer advantages for saving. An individual retirement account (IRA) will have a greater variety of investment options, but only a 401(k) has the potential for employer matching funds.

A 401(k) also allows for greater contributions than an IRA. Here are the current contribution limits:

• For 2024, the 401(k) contribution limit is $23,000 (plus a $7,500 catch-up for people aged 50 and older).
• For 2024, IRA contributions are $7,000 (plus a $1,000 catch-up for those aged 50 and older.)
• For 2025, the 401(k) limit is $23,500 and the catch-up stays at $1,000.
• The 2025 limit for IRAs remains at $7,000, and the catch-up remains at $1,000.

Do You Need a 401(k) and a Savings Account?

A 401(k) and a savings account serve entirely different purposes.

A savings account is a necessity to take care of unexpected expenses. The interest you’ll earn on the account is abysmally low but the money will be there when you need it.

It is difficult and expensive, if not impossible, to take money out of a 401(k) before you reach retirement age. But it has the potential to grow into a substantial sum that you can rely on for living expenses after you retire.

The Bottom Line

The 401(k) plan has become the cornerstone of retirement planning for most U.S. wage earners. They can be of great benefit to you. But move cautiously and consider how you can make the most of your 401(k) and even take advantage of some other available options such as an IRA.