In 1982, the 401(k) plan was introduced. For a large number of American workers this is the main retirement savings vehicle provided by their employer. It has supplanted the defined benefit pension plan at most companies.
Photo by Carolyn Forsyth
Do I need a 401(k)?
The answer is… YES!
A 401(k) provides the following benefits:
The funds are placed in your account pre-tax. So, if your tax rate is 20% you get $1.00 instead of 80 cents. You will pay taxes when you withdraw funds from your 401(k) but the expectation is that you will have a lower tax rate (if retired) or you will be using funds for an important purpose (home purchase, college costs, medical need).
Your company may offer matching contributions up to a given percentage (usually 3% to 5%). If so, make sure that you capture all of those matching funds. That gives you an extra savings amount.
The funds are captured monthly and you don’t have to think about it. That means it happens every month and helps you build your savings.
In general, the fees are generally less than if you were doing this as an individual. This is not true in all cases but generally your company will be able to get a lower fee for the investors in their 401(k).
These benefits make the 401(k) an efficient way to save money for future use.
Are their risks? Of course there are risks. The days of the 5% savings account (guaranteed by the FDIC) are long gone. You have to select an investment fund or funds where your money is directed. That choice should be appropriate for your age and financial plan (too conservative and you forego earnings, too aggressive and you risk losses). Some funds have inappropriate fees. Some funds are badly managed. All of these issues exist with or without a 401(k). So utilizing an investment vehicle that has some additional benefits is a good approach.
Do I need an IRA?
An IRA (Individual Retirement Account) does not have the same benefits as a 401(k). Contributions (other than a rollover from a 401(k)) are usually after-tax and the individual pays the fees for maintaining the account. There will not be a company contribution.
If you leave an employer where you have a 401(k) you can transfer the funds from the 401(k) to an IRA (the transfer has special rules so that you do not trigger a taxable event). The advantage in moving the funds from the 401(k) to the IRA is that you have more control over the investment choices. You are no longer limited to the choices of your previous employer's 401(k) plan.
The tax advantage of the IRA is that funds are not taxed until they are removed from the IRA. You may buy and sell stocks, bonds, mutual funds and U.S. Treasuries and not incur a taxable event until the funds are removed from the IRA. Ideally, when you do remove the funds, you are in a more favorable tax position.
You will need an IRA if you have to move your funds from a company 401(k) to maintain the tax status of the funds. An IRA is another way to invest funds for the future and defer the taxes.