What does a 401k mean and is a 401k worth it anymore?
If you are planning to start 401k and wondering is a 401k worth it anymore, than you came to the right place. In this article, we will provide you all the informations you need to make the decision and help you make smart personal finance decision.
401k plans are offered by employers and it is popular method of investment in the United States. It is a tax-deferred plan which means that these savings are taxed at the time of withdrawal. This article explores all the myths regarding whether a 401k is worth it anymore.
In accordance with this plan, the employers deduct an arbitrary amount of money from each paycheck which forms up this 401k. To dig deeper into this phenomenon, we’ll have to discuss some pros and cons of having a 401k account.
Earning money through 401k
The most widely used way of earning money through a 401k is investing in the stocks business. A very intuitive and major reason for this is that investing in stocks is a quite stable and safe way of earning money if you invest for long term.
Diversify you stock investment, this will reduce the overall risk and help you optimize you return and investment.
There are a lot of these on your employer’s panel to choose from so how to choose the best one?
The rule of thumb, of course, is to choose the one with low fees. The problem arises when a low fee fund is not available on the employer’s panel. Expense ration parameter can be used to check how good a fund is for your investment. The expense ratio gets taken away automatically by your investment holder. For example, if 0.5% of the expense ratio is claimed, 0.5% of your funds would be charged annually.
Another concept called, the compounding effect comes into play when earning money through this 401k. This refers to the interest that you will earn on this money over time. The interest you earn sums up to the total amount, which means that you’ll be earning interest over the interest money too. Isn’t this a really wild concept? Well, if you have decided to opt for a 401k, then it is indeed, a wild concept.
How can 401k be bad after all this earning it does?
Things have been quiet in favor of 401k so far. So why is there even a question that is a 401k worth it anymore? Well, there are some certain repercussions that clearly show that 401k is not the slam-dunk winner when it comes to retirement saving plans.
Although investing in stocks is a stable approach, but with aging, there is a need to move to a larger bond vs stock mix. This results in a decreased progression of the investment with growing age. Early on investment risk tolerance is higher and a larger amount of money is invested in stocks than bonds. However, getting older prevents you from taking greater risks and so you naturally gravitate to investing more money in bonds than stocks, which do guarantee better stability but inhibits a greater rate of return.
This clearly implies that this is a trade-off between higher returns and a lower level of risk. Closer to your retirement age, a major part of your money is invested in low-risk products that yield a lower rate of return.
So, is 401k worth it anymore? Using 4% retirement rule to explain it
Analysis of retirement funds showed that to properly sustain the nest egg (i.e, the account balance), only a specific percentage of the funds can be drawn annually or monthly.
Excessive withdrawal will have an adverse effect on the remaining money. It won’t be able to yield enough interest and the 401k will deplete ultimately. So what exactly is the 4% retirement rule?
As you would have guessed by now, the certain percentage that can be drawn at a time out of your retirement fund is 4%, which is not a lot at all.
What else can deplete away the 401k?
Another factor that can eat away your 401k is inflation. We normally ignore this factor but researches have shown that it plays a significant role in expending the retirement fund. Prominent research showed that even a 1% inflation rate (which is quite feasible) can cost up to 40k bucks of money to a retired person. Doesn’t this make 401k plan a bad one?
Forced withdrawals are also something that makes a 401k not worth it anymore. So, what exactly are these forced withdrawals? This means that a person cannot contribute to their 401k after a certain age i-e 70 and a half years. Age was selected after considering the fact that an average person can’t really contribute after this age. But those who can, are at a severe disadvantage.
As discussed before, a 401k plan is a tax-deferred one. This means that you still have to pay tax on your money. Does it really matter that you’ve to pay taxes only when you withdraw the money? A scary part of this transaction is that the tax is cut as a whole. Hence, this can consume a very large portion of the total savings.
Apart from this, another major disadvantage of this plan is the restrictions that the employers imposes while you’re contributing to your 401k. Long waiting periods and a limited contribution amount are on top of this list. A person cannot start contributing before a specific time. And you can’t even control the amount of contribution that you want to make. Both these factors can be troublesome for those who really want to start contributing early or those want to contribute a larger sum of money.
There is something else that most people don’t realize while going for the 401k plan. The person choosing this plan for their retirement, cannot enjoy any insurance benefits. So, if in any case, you lose your money that’s in a 401k plan, you’re in a severe deadlock. So, a quick and vigilant look at the investment at all times is necessary.
In Nutshell: Is a 401k worth it anymore
So now we come back to the ultimate question, is a 401k worth it anymore? Considering the factors discussed above, it is quite clear that no, a 401k isn’t the best investment option anymore. There are certain advantages in using this plan as a retirement fund but this isn’t the best one out there considering its stability, reliability and its overall worth. In a nutshell, the disadvantages of the plan outweigh its advantages.
However, I highly recommend that you take advantage of it if your employer offers matching investment. If you want learn more about 401k taxes, check this article on 401k taxes.