How Well Do You Know Your 401(k) Plan?

401(k) plans offer a variety of unique benefits ranging from company matches, to plan loans, to the ability to take penalty-free distributions before age 59½. In this piece, we share ten unique advantages of participating in your 401(k). Read on to test how well you know your plan, and if you have any questions specific to your 401(k) or other retirement account, Yeske Buie is always available to provide insight and answers based on your personal needs.

Ten Unique Advantages of Your 401(k) Plan

1. Employer Match

Many employer-sponsored 401(k) plans offer a match up to a certain percentage of your contribution and salary.  This is a special feature that you won’t find with an IRA and several other retirement vehicles.  At a minimum, it is a good idea to contribute at least up to the amount that your employer will match.  Otherwise, every dollar that misses out on your employer’s match is a dollar of “free” cash left on the table.

2. The Age 55 Penalty-Free Provision

The “Age 59 1/2 Rule” is often referred to as a rule of thumb in determining whether distributions from a retirement plan will be subject to the 10 percent tax penalty. While generally true with non-qualified early IRA distributions, 401(k) plans possess a special provision that allows participants who leave their employer after age 55 to take penalty-free distributions! Note that IRAs also allow withdrawals before age 59 ½, however they must be “substantially equal periodic payments,” whereas a 401(k) plan participant can withdraw any amount of the plan balance at any time with this provision.

3. Creditor Protection

401(k) plans are governed by the Employee Retirement Income and Security Act of 1974 (ERISA) that protects qualified plan assets from creditor claims in bankruptcy. This is a significant advantage over other tax-advantaged plans like IRAs which do not receive total protection in bankruptcy.

4. Plan Loans

While we generally advise against borrowing from retirement savings to fund other needs, 401(k) plans may allow you to take a loan from yourself that is not subject to penalty if you stay employed and if paid back within the specified term, usually five years. Although you will pay interest on the loan comparable to the rate charged on a similar consumer loan, the interest is paid back into your account instead of a bank and this type of loan does not appear in your credit report.

5. Roth Accounts Not Subject to Income Limitations

Employer-sponsored 401(k) plans are increasingly permitting designated Roth contributions that allow you to make deferrals with after-tax dollars. Not only do the employee contributions grow tax-free and will be distributed tax-free at retirement, you are also not subject to the income limits that exist with Roth IRAs.

6. Two-Fold Tax Advantages

While you receive a tax deduction in the year of your pre-tax contributions, your contributions also grow tax-deferred. Although you will owe taxes when you distribute the money (except for your Roth contributions), you may likely be in a lower tax bracket at retirement and therefore be paying less taxes at that time than you would during your working years.

7. Built-in Dollar Cost Averaging

Dollar-cost averaging is an investment strategy of buying a fixed dollar amount of shares over a period of time, regardless of share price. The fixed periodic contributions to your 401(k) plan every pay period is, in effect, a method of dollar cost averaging because your contributions are consistently invested over a time period that allows you to buy low and sell high. When prices are high you buy fewer shares, and when prices are low you buy more shares. This technique tends to lower the average cost of all of your shares.

8. Net Unrealized Appreciation

If your employer retirement plan has an employee stock ownership plan within it, the distribution of company stock at retirement will likely enjoy favorable tax treatment. For example, if your employer granted you $20,000 of company stock twenty years ago and you retired today when the stock was valued at $100,000, you would pay ordinary income tax on the $20,000 in the year you retire. Once you decide to sell the stock, the $80,000 of growth will enjoy the lower long-term capital gains rate and any other growth above that will be treated as short or long term capital gain depending on how long you held it before selling.

9. Higher Contribution Limits Mean Higher Tax Deductions

The maximum deductible deferral to your 401(k) plan for 2023 is $22,500 with a $7,500 catch-up contribution for those participants age 50 and over.  This greatly exceeds the maximum deductible contribution to an IRA in 2023 of $6,500 with a $1,000 catch-up contribution for those age 50 and over. The more you defer, the more you can deduct and save in taxes and the more you are setting your future self up for financial independence!

10. Simplicity of Investment Options and Ease of Saving

Usually the plan administrator has done much of the leg work in offering a variety of mutual funds to achieve diversification. Oftentimes, we help Clients determine the appropriate funds that fit their needs and best mirror our investment philosophy. Once you enroll and determine your contribution amount and investment choices, you have “set it” and can now “forget it” because your contributions are automatically deducted from your paycheck, no checkbook necessary!