Having access to a 401(k) plan isn’t a given. If you work for a smaller company, you may not have one of these plans available to you. But if your company does offer a 401(k), you may be tempted to sign up. Before you do, make sure you understand the pros and cons of 401(k)s — and that includes getting to the bottom of these lies you may have heard.
1. A 401(k) is the best place for your retirement savings
Since 401(k) plans offer higher contribution limits than IRAs do, you may have been told that they’re your best retirement savings option. But that’s not necessarily true.
This year, 401(k)s max out at $23,000 for savers under age 50 and $30,500 for those 50 and over. But that’s a lot of money to part with. If you’re an average earner, you’re probably not contributing above the current limits for IRAs, which are $7,000 if you’re under 50 or $8,000 if you’re 50 or older.
Meanwhile, 401(k)s limit your investment choices more than IRAs do. With a 401(k), you generally cannot invest your retirement funds in individual stocks, whereas with an IRA, you can. That means you may not be able to build a portfolio that aligns well with your goals and strategy.
Now, one benefit of having a 401(k) is that many of these plans come with an employer matching incentive. You could score some free cash for your retirement by making contributions out of your own paychecks. In that case, it could make sense to fund your 401(k) up to the amount your employer will match, and then allocate subsequent dollars for retirement savings to an IRA.
2. Borrowing against a 401(k) is a great option when you need a loan
Another difference between IRAs and 401(k)s is that with the former, you generally cannot take out a loan against your balance. But many 401(k) plans allow savers to take out loans.
You might assume that taking out a 401(k) loan is a great option when you need money. That way, you don’t have to go through the process of applying elsewhere. And instead of paying interest to a lender, you can simply repay yourself.
But you should know that if you fail to repay a 401(k) loan on time, that sum will be treated as a full-fledged distribution. If you’re not yet 59 1/2 years old, that will then result in a 10% early withdrawal penalty.
Plus, while you might initially have a longer window to repay a 401(k) loan, once you separate from your employer — voluntarily or otherwise — your repayment window might shrink to just a couple of months. The specifics will depend on your plan, but the point is that taking out a 401(k) loan is risky — and it’s something you may want to avoid.
Remember, too, that if you don’t repay a 401(k) loan, you’ll have less money available for your senior self in retirement. That could hurt you financially down the line.
3. Mutual funds are the best option for investing your 401(k)
Since you can’t invest a 401(k) in individual stocks, your options are generally a mix of different funds. You may have heard that mutual funds are the best place to put your money if you have a 401(k). But the problem with mutual funds is that they tend to charge high fees, known as expense ratios, that can erode your 401(k)’s returns over time.
Instead of loading up on mutual funds, consider putting your money into index funds, which you’ll commonly find in a 401(k). Index funds are passively managed, so their fees tend to be considerably lower than what mutual funds charge. Plus, historically, index funds have managed to outperform their actively managed mutual fund counterparts, all the while saving investors money on fees.
If you’re going to save for retirement, it’s important to find the right home for your money and the right investments within that account. Don’t buy into the notion that a 401(k) is automatically your best choice, and don’t assume that within a 401(k), mutual funds are your best option. And for the sake of your future financial comfort, resist the temptation to borrow against your 401(k), even though it might seem like a savvy move at first.
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