401(k) Plans Still Make Sense. Here Are Four Reasons Why.

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 advisor, 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.

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

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 Price¹ in 2022 showed that 86% of employees participated in their plan if it was set up for auto-enrollment. For other types of plans, the participation rate was only 37%. The gap is even wider for workers under 30. Fortunately, employers’ adoption of auto-enrollment has steadily risen from 51% to 66% over the past seven years. These figures tell a story: People need help with saving, and retirement plans are increasingly helping them.

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 that 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. Even if your tax rate doesn’t decrease in retirement, tax deferral generally works out better long term than a nonretirement account.

If you expect a higher tax rate later, Roth contributions may help you. Eighty-seven percent of retirement plans now offer them, and that figure is likely to rise even higher due to provisions in the SECURE 2.0 Act passed in late 2022. 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 account² 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.

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. Eighty-eight percent of plan sponsors with 5,000+ employees offer a match—plus over 74% 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.

One criticism of retirement plans is that some employees could use more help with other aspects of their financial lives. The SECURE 2.0 Act enables plan sponsors to promote retirement saving in conjunction with student loan payments and building an emergency fund. Congress seems to appreciate that the combination of behavior encouragement and a well-established platform is very powerful.

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, 97% of retirement plans offer target date investments, and they are often set as the default option. Target date investments are goal-oriented and automatically adjust your risk level over time. In addition, 85% 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 still be changed to further 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.