401(k)s

4 Reasons 401(k) Plans Still Make Sense

These tax-advantaged accounts remain the backbone of a retirement saving strategy, despite what naysayers might argue.

From time to time, you may see articles on the drawbacks of 401(k) retirement plans. While it is important to understand the limitations of any investment account, when pundits start claiming that 401(k) retirement plans don’t make sense for most people, I feel the need to speak up. When I was a financial adviser, nearly all of my clients — across a wide variety of income levels — built their foundation for retirement with 401(k) plans. I would hate to see people read negative articles and decide not to participate in retirement plans. 

I should state upfront that I work for an investment management company that serves investors in 401(k) plans and other types of accounts. I am a longtime advocate of retirement plans and can support my view with analysis and real-life experience.

There are four major benefits of retirement plans that stand out to me:

1. Automatic saving

The behavioral benefit of automatically saving for retirement each pay period should not be understated. There is abundant research showing that people tend to stick with default actions, such as automatically contributing to a 401(k). Data from retirement plans served by T. Rowe Price* in 2019 showed that 85% of employees participated in their plan if it was set up for auto-enrollment. For other types of plans, the participation rate was only 44%. The gap is even wider for workers under 30. Fortunately, employers’ adoption of auto-enrollment has steadily risen from 44% to 62% over the past seven years. These figures tell a story: People need help with saving, and retirement plans are increasingly helping them.

2. Tax benefits

Considering the downward trend in statutory tax rates over recent decades, do “tax-advantaged” retirement accounts really help? Having conducted thorough analysis in this area, I am confident they do.

It’s true, while you get a nice tax break on the money you contribute to a traditional 401(k) account, once you start making withdrawals in retirement, you will pay taxes on every dollar you take out. However, many people will have a lower effective tax rate in retirement than the marginal rate during their working years. That makes deferring taxes via a 401(k) plan beneficial.

If you expect a higher tax rate later, Roth contributions help you, and 77% of retirement plans now offer them. You pay taxes on the money you contribute to a Roth, but after that the principal and gains can be tax-free via qualified withdrawals.  If instead you grew your portfolio using a taxable (nonretirement) account, even with income low enough to avoid taxes on long-term capital gains, a Roth account would still be at least as good tax-wise.** Ultimately, tax-deferred growth, with either traditional or Roth savings, can go a long way toward meeting your retirement goals.

3. Employer contributions

Taking advantage of an employer’s 401(k) match may be the first personal finance advice you get upon entering the workforce. It’s often referred to as “free money” and is a significant, straightforward and common benefit. Over 90% of plan sponsors with over 1,000 employees offer a match — plus 76% of smaller plans. The most common match formulas incentivize employees to contribute at least 4% to 6% of their pay. Many employers contribute up to 3%, and matching formulas up to 4% or 5% are becoming more popular. Again, the trends have generally moved in the right direction, at least before the pandemic. Could employers help workers in ways outside a retirement plan? Yes, but the combination of behavior encouragement and a well-established platform is very powerful.

4. Help with investing — and staying invested

Have you ever been paralyzed by a bewildering array of toothpaste at the store? A similar feeling can come over retirement savers when it comes to investment selections. Fortunately, 96% of retirement plans offer target-date investments, and often they are set as the default option. Target-date investments are goal-oriented and automatically adjust your risk level over time. In addition, nearly 80% of plans allow investors to automatically increase contribution percentages periodically, with nearly half of those plans setting auto-increase as the default. And, importantly, it is possible to get your money out before retirement if necessary, but there are large incentives not to do so. If you need help, your employer will likely provide education and guidance, regardless of your asset level. 

Of course, there is a range of quality and cost among 401(k) plans. And all types of investment accounts have advantages and disadvantages.  Regulations around retirement plans, taxation, and Social Security could all be changed to improve Americans’ retirement security.  None of that leads me to believe that retirement plans don’t make sense for savers today.

I want clients to prepare successfully for retirement, regardless of what types of accounts or investments they use. Retirement plans have helped a lot of people, including me, and I encourage investors to continue reaping their benefits.

*All statistics about retirement plans are from T. Rowe Price Reference Point.

**Assuming qualified Roth distributions, which generally require age 59½ and the account being open for five years.

This material is provided for general and educational purposes only, and not intended to provide legal, tax or investment advice. This material does not provide recommendations concerning investments, investment strategies or account types; and not intended to suggest any particular investment action is appropriate for you. Please consider your own circumstances before making an investment decision.

About the Author

Roger A. Young, CFP®

Senior Financial Planner, T. Rowe Price

Roger Young is Vice President and senior financial planner with T. Rowe Price Associates in Owings Mills, Md. Roger draws upon his previous experience as a financial adviser to share practical insights on retirement and personal finance topics of interest to individuals and advisers. He has master's degrees from Carnegie Mellon University and the University of Maryland, as well as a BBA in accounting from Loyola College (Md.).

Most Popular

Where's My Stimulus Check? Use the IRS's "Get My Payment" Portal to Get an Answer
Coronavirus and Your Money

Where's My Stimulus Check? Use the IRS's "Get My Payment" Portal to Get an Answer

The IRS has an online tool that lets you track the status of your stimulus checks.
February 19, 2021
Want More Tax-Free Retirement Income? One Man’s Whole Life Decision
life insurance

Want More Tax-Free Retirement Income? One Man’s Whole Life Decision

Whole life insurance might not be something that’s on your retirement planning radar, but for this client, here’s how it served his need to control ta…
February 23, 2021
The Current Plan for $1,400 Checks
Coronavirus and Your Money

The Current Plan for $1,400 Checks

Here's what you need to know about the stimulus check plan currently being considered in Congress for President Biden's COVID-relief package.
February 18, 2021

Recommended

Why I’m No Fan of Trading Apps That Treat Investing Like a Game
investing

Why I’m No Fan of Trading Apps That Treat Investing Like a Game

In the wake of the GameStop saga, an investment professional shares his take on the rush of people buying into “hot stocks” only to get into hot water…
February 24, 2021
How Savers Can Earn More on Their Money, and Do It Safely
annuities

How Savers Can Earn More on Their Money, and Do It Safely

With interest rates perpetually doing the limbo (how low can they go?), here are three different types of fixed annuities that can be good alternative…
February 24, 2021
Want More Tax-Free Retirement Income? One Man’s Whole Life Decision
life insurance

Want More Tax-Free Retirement Income? One Man’s Whole Life Decision

Whole life insurance might not be something that’s on your retirement planning radar, but for this client, here’s how it served his need to control ta…
February 23, 2021
Yours, Mine … and Maybe Ours? Advice for Couples on How to Handle Money
personal finance

Yours, Mine … and Maybe Ours? Advice for Couples on How to Handle Money

Picking the right money-handling strategy for your family – separate finances, a joint account or something in between? – can make a big difference on…
February 23, 2021