Almost every financial adviser recommends having a 401(k)… but are they the surefire solution they’re made out to be?
Employee funding comes directly off their paycheck and may be matched by the employer. There are two main types corresponding to the same distinction in an Individual Retirement Account (IRA); variously referred to as traditional vs. Roth, or tax-deferred vs. tax-exempt, or EET vs. TEE. For both types profits in the account are never taxed. For tax-exempt accounts, contributions and withdrawals have no impact on income tax. For tax-deferred accounts, contributions may be deducted from taxable income, and withdrawals are added to taxable income. There are limits to contributions, rules governing withdrawals, and possible penalties.
Employers are allowed to automatically enroll their employees in 401(k) plans, requiring employees to actively opt-out if they do not want to participate (traditionally, 401(k)s required employees to opt-in). Companies offering such automatic 401(k)s must choose a default investment fund and saving rate. Employees who are enrolled automatically will become investors in the default fund at the default rate, although they may select different funds and rates if they choose, or even opt-out completely.
Automatic 401(k)s are designed to encourage high participation rates among employees. Therefore, employers can attempt to enroll non-participants as often as once per year, requiring those non-participants to opt-out each time if they do not want to participate. Employers can also choose to escalate participants’ default contribution rate, encouraging them to save more.
Two Cents was created by Katie Graham, Andrew Matthews, Philip Olson CFP®, and Julia Lorenz-Olson and is brought to you by PBS Digital Studios.