Investing in 401(k) Plan vs Investing in Stocks
Investing via a 401(k) retirement plan offers immediate, pre-tax savings on your contributions. Your income is reduced by the amount of your contribution before any taxes are withheld from your pay or counted as part of your taxable income.
One major disadvantage to 401(k) accounts becomes evident when you take money out: any withdrawals are taxed as regular income.
So, if you withdraw money in, say, the 20% tax bracket, you’ll pay taxes at that rate on all the funds you take out – including your original contributions and all the investment gains.
Some 401(k) plans include a matching contribution from your employer. If your match is, say, 100% of the first 3% of employee contributions, you receive an immediate 3% return on your investment.
No Comparable Tax Benefits
Investments in individual stocks offer no comparable tax benefits. However, some stockbrokers allow investors to purchase pre-IPO shares (privately held companies that are not yet publicly traded) in their taxable accounts.
These shares often offer an enormous return on investment, but have strict terms, are not guaranteed to work out, and do not always provide the same protections for your money that a more established company might.
Others have restrictions on what can be done with your funds when you leave the company. It’s either in the form of a withdrawal fee or in full forfeiture if you don’t roll your money into an IRA within so many days after leaving your job.
On the other hand, investing in individual stocks offers a great deal of liquidity. You can buy and sell stocks as you please, within the limits of your available funds. This enables you to tailor your portfolio to match your specific risk tolerance and time horizon.
Pros and Cons of Investing in a 401(k)
Pros of Investing in a 401(k) Include:
Immediate Tax Savings
Contributions to a 401(k) account are made before taxes are deducted from your pay. This lowers your taxable income for the year.
Employer Matching Funds
Some employers match employee contributions, like getting an immediate return on your investment.
Funds Are Not Taxable When Withdrawn
Money taken out of a 401(k) account is not taxed as regular income. This only applies to withdrawals made after you have stopped working for the company that sponsors your 401(k) plan.
Funds Are Usually Invested in Low-Risk Options
Employers often choose low-risk mutual funds for401(k) plans since this is most likely to be suitable for most employees.
The Cons Include:
Most 401(k) plans only allow investment in predetermined mutual funds. If you don’t like the funds your plan provides or if they happen to be performing poorly, you’re stuck.
You Can’t Take Your Money Out Until You’re 59.5 Years Old
If you need to access your funds before that age, you’ll have to pay the penalty and regular income taxes for the withdrawal.
Forfeiture of Employer Matching Funds if You Don’t Remain Employed With the Company Until Retirement
Once you stop working for a company that sponsors your 401(k) plan, it can take back any money they contributed on your behalf should you leave the company before reaching the age of 59-1/2.
Limited Variety of Investment Options
Most 401(k) plans only offer low-risk mutual funds. If most of your assets are tied up in this type of fund, you may not be able to reach your long-term investment goals.
Pros and Cons of Investing in Stocks
Pros of Investing in Stocks Include:
Ability to Create a Personalized Portfolio
You can invest in any company or company you please within the limits of your available funds. This allows you to tailor your portfolio to match your specific risk tolerance and time horizon.
Higher Potential Returns
Stocks have notably offered a higher rate of return than the average mutual fund, but this may not be true in the future.
Higher Potential for Loss
Stocks are riskier investments than 401(k) accounts or low-risk mutual funds since they offer a higher rate of return. This also means you could potentially lose your entire investment.
The Cons Include:
Possibility of Losing Your Entire Investment
Stocks are riskier investments than 401(k) accounts or low-risk mutual funds. This means you could lose your entire investment if the stock market crashes.
You need to be willing to spend time monitoring your portfolio to make sure it stays on track.
If you invest in individual stocks, you pay taxes on any money made from selling or redeeming shares. This is not the case with 401(k) plans or low-risk mutual funds.
How to Decide Which Investment Is Right for You?
When deciding whether to invest in a 401(k) or stocks, it’s essential to consider your specific goals and risk tolerance.
If you are thinking of a low-risk option with minimal maintenance, a 401(k) may be the best choice for you. But if you’re willing to take on more risk in order to potentially earn a higher return, stocks may be a better option.
It’s crucial to remember that there is no one-size-fits-all answer. The best investment for you may vary depending on your age, income, and other factors.
It’s also essential to be aware of the risks and rewards associated with each investment before making a decision. Considering the pros and cons of each option will help you make a more informed decision about where to invest your money.
Lastly, remember that it’s important to invest for the long term. Don’t try to time the market – you’re more likely to lose money that way. Instead, find an investment that aligns with your goals and risk tolerance, and stick with it.
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.