May 17, 2024
More than 4-in-10 Americans risk missing out on one of the best available tools for building a secure retirement.
That troubling stat comes from a new Beyond Finance in which 43% of respondents admitted they don't know what a 401(k) is.
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It's not surprising so many people are in the dark. Financial education is lacking in the U.S. and the term 401(k) isn't very exciting. It's a problem, though, because the benefits of a 401(k) are impressive enough that they're worth paying attention to.
Here's what to know to decide if this powerful wealth-building account could work for you.
401(k)s can offer retirement security
A 401(k) is a tax-advantaged retirement investment account and a type of defined contribution plan. You get tax breaks for contributing to it, but aren't guaranteed any set payments in retirement (like you would be with a defined benefit pension) as payouts depend on your investments.
In addition to the tax breaks a 401(k) offers, many companies also offer matching contributions. That means your company contributes to your account when you do. While there are different arrangements, the most common, according to Fidelity, is a 100% match on contributions up to the first 3% of your salary, then a 50% match on the next 2%. This works out to a 4% match if you invest 5% of earnings.
With the tax break and employer match, you can invest small amounts and end up with a big balance. Contributing 5% of a $50,000 salary saves you up to $550 on your taxes if you're in the 22% bracket. Your $2,500 contribution reduces after-tax take home pay by only $1,950. With your employer adding another $2,000, you end up with $4,500 saved for your future. A $4,500 annual contribution invested at 10% average returns for 30 years turns into over $740,000.
That's a lot of money for the 43% of Americans who don't know about 401(k)s to miss out on.
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Beware these 401(k) pitfalls
While 401(k)s are powerful accounts, they aren't perfect.
For one thing, you usually need an employer to invest in one. The good news is, around 66% of private industry workers had access to defined contribution plans in 2023, according to the Bureau of Labor Statistics. Still, many are left out.
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You'll also have access to a limited investment mix. The typical 401(k) offers a choice of only around 13 funds according to the Investment Company Institute.
If you leave your job, you'll also have to decide whether to leave your 401(k) with your past employer (which puts you at risk of forgetting the account) or jump through some hoops to roll it over to a different retirement plan.
Now, these disadvantages are worth overlooking to earn your employer match. But, once you've done that — or if you don't have 401(k) access — you may want to consider alternatives.
Consider these alt retirement accounts
The good news is there are great 401(k) alternatives out there. An IRA is one of them.
Anyone can open an IRA with any broker, and, if your income isn't too high, you can make tax-deductible contributions. You'll also have more investment choices. Unfortunately, there's no employer match with these accounts.
For those without a 401(k), an IRA may be your best chance to get tax breaks for retirement savings. If your employer does offer a workplace plan, you may still want to fund an IRA (once you’ve maxed out your 401(k) contributions) to access more investments.
Whatever you decide, understanding a 401(k) is a good first step towards making informed choices about retirement savings.
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Christy Bieber has 15 years of experience as a personal finance and legal writer. She has written for many publications including Forbes, Kilplinger, CNN, WSJ, Credit Karma, Insurify and more.
