Do 401(k) Plans Still Make Sense For Savers?

Does the 401(k) no longer make sense? That’s what a recent article in Bloomberg Opinion is claiming because of lower tax rates and lower fees on investments outside of 401(k) plans. Before you cancel your 401(k) contributions, let’s look at some reasons the 401(k) still generally makes sense for people looking to save for retirement.

1) Employer match. The average employer match is about 4.7% of your income. Would you turn down a bonus equal to almost 5% of your income? When you fail to contribute enough to your 401(k) to get the full match, you’re leaving that free money on the table.

2) Tax benefits. The article points out that the marginal federal income tax rate was 43% in 1980 and 12% today. First, if your AGI is over $40,125 as a single person or $80,250 as a couple, then you’ll likely be in a tax bracket of 22% or more. Even if you’re in the 12% tax bracket, pre-tax 401(k) contributions are still reducing your tax liability.

More importantly, you’re likely to pay a lower average tax rate on the money when you withdraw it in retirement even if you retire in the same tax bracket! First, don’t forget that not all your income will be taxable in retirement. Even if you have no other tax breaks, you’ll still be eligible for at least the standard deduction plus an extra amount if you’re age 65 or older and your Social Security at most will only be partially taxable depending on your “combined income.” Any withdrawals from Roth accounts may be tax-free and only earnings on outside savings and investments are taxable (as opposed to any principal that you sell or withdraw).

We also need to examine what we mean by “tax rate.” For example, let’s say you currently earn  a joint taxable income of $100,000. That would put you in the 22% tax bracket. If you contribute $19,500 pre-tax to your 401(k), all $19,500 would otherwise have been taxed at that 22% rate.

Let’s say you then retire with the equivalent of $85,000 of taxable income (including RMDs) and are still in the 22% tax bracket. However, only the taxable income above $80,250 (in today’s dollars but the brackets are adjusted for inflation) or less than 5% of your taxable income is taxed at that 22% rate. This means your average or effective tax rate would be only 12.09%, despite still being in the 22% tax bracket. Would you rather pay a tax rate of 22% now or 12.09% later?

What if you’re worried that your tax rates will actually be higher in retirement? This could be because your income is higher or the tax rates are higher in general. In that case, find out if your plan offers a Roth option that provides no tax benefits now but allows your money to grow and eventually be withdrawn tax-free.

3) Fees. It’s true that fees are really important and there are a lot of low cost investment options now, but fortunately over 90% of 401(k) plans with at least $10 million in assets offer low cost index funds too. If this is not the case for you, see if your plan offers access to a brokerage window that lets you invest in almost any mutual fund you’d like. You can also look for other funds in your plan with a low expense and turnover ratio.

4) Loans. Unlike IRAs and regular taxable accounts, your 401(k) plan may provide you the option of borrowing from your account and then paying it back into your account (with interest). This way you avoid the tax implications of having to sell an investment or withdraw from an IRA if you’re in a financial jam.

5) Convenience. In some ways, the most important benefit of a 401(k) is the most overlooked. That’s the convenience of having your payments deducted from your paycheck before you even have a chance to spend it. After all, how many of us would contribute as much if we had to write a check into our 401(k) plan?

None of this is to say that everyone should max out or even contribute to your 401(k) plan at all. If you’re unable to pay your essential bills, building up your emergency fund, paying down high-interest debt, or saving to buy a home, you might have other financial priorities right now. But for anyone planning to save for retirement, the death of the 401(k) has been greatly exaggerated!