This year marks the 40th anniversary of the 401(k) retirement savings account. Well, technically, it’s the 40th anniversary of the Revenue Act of 1978, which is what made such accounts possible, with section 401(k) of the Act giving workers a tax-free way to defer compensation. Retirement accounts named for the section became available several years later.
But why quibble when you have a good excuse to remind readers of key ways to make the most of such accounts and introduce a new SMI tool to help you choose between a 401(k) plan and an IRA?
Even after 40 years, 401(k) plan critics continue to bemoan the loss of defined-benefit plans. Those critics include some of the very people who helped invent the 401(k) plan, such as Ted Benna, a former benefits consultant.
Section 401(k) of the Revenue Act of 1978 allowed workers who received bonuses or stock options to defer taxes on such payouts. However, Benna saw in the new tax code the possibility that workers could save a portion of their income in a tax-advantaged way. The IRS soon agreed and companies began embracing what were then described as “salary reduction plans.” Such plans were attractive to companies because they were far less expensive to operate than defined-benefit plans.
According to Benna, 401(k) plans were intended to supplement traditional pensions, not replace them. He also believes Wall Street has benefited from the plans more than Main Street due to various fees charged to participants.
Not all bad
Love ‘em or hate ‘em, the reality is that 401(k) plans and their close cousins, 403(b) and 457 plans, along with the government’s Thrift Savings Plan, are the primary ways today’s workers can make tax-advantaged investments for their retirement. According to the Department of Labor, nearly 60% of workers have access to a 401(k) plan.
While there are certainly still some high-fee plans with poor investment options, fees have been coming down, transparency has been going up, and 401(k) plans generally offer numerous benefits, such as:
Portability. With traditional pensions, workers typically had to stay at one employer for a long time in order to collect. With 401(k) plans, when you leave an employer you can keep the money where it is, roll it into a new employer’s plan, or roll it into an IRA.
High contribution limits. 401(k) plans allow you to save a large amount of money in a tax-advantaged way. The annual contribution limit for 2019 will be $19,000 — up from $18,500 in 2018.
Matching money. According to the Bureau of Labor Statistics, a little over half of employers with a 401(k) plan offer some type of match on employee contributions. This is arguably the single greatest benefit of 401(k) plans. A match is free money. If your employer will match your contributions dollar for dollar (often up to six percent of your salary), that’s a guaranteed 100% return on your money.
Target-date funds. At many workplace retirement plans, the most popular investment is a target-date fund. Such funds make it easy for employees to get the important asset allocation decision mostly right, and they then manage that allocation over time, making portfolios more conservative as participants near retirement.
To be sure, there are some watch-outs here. For example, one mutual fund company’s target-date fund will not use the same asset allocation as another company’s fund, even when comparing funds that target the same retirement date. If you’re going to use a target-date fund, you should independently evaluate your optimal asset allocation and then choose the fund whose asset allocation most closely mirrors it.
Automation. An increasing number of employers are automatically enrolling new hires into their 401(k) plan and in some cases choosing investments and increasing employee contributions over time. This change — from an opt-in system to an opt-out system — has been successful in driving up participation rates.
Here again, this solution isn’t perfect. As The Wall Street Journal has documented, with so many decisions being made for employees, some participants seem to not appreciate that such accounts are for retirement. The Journal highlighted employees who were surprised at their growing account balances and then wanted their money, often making withdrawals via loans. (We’ll have more to say on this in the December issue of the SMI newsletter.)
How to decide between a 401(k) and an IRA
If you’re trying to figure out whether it would be best to contribute to your workplace retirement plan or use an IRA instead, take a look at our brand new 401(k)/IRA decision tree. By answering just a few questions, you’ll find the best option for you.
Do you have access to a 401(k) plan where you work? Are you taking full advantage of its benefits?