401(k) Plan Pros And Cons

Written by True Tamplin, BSc, CEPF® | Reviewed by Editorial Team

Updated on December 13, 2022

401(k) plans are the most common type of retirement savings plan in the private sector. They allow employees to save for their retirement on a tax-deferred basis and also count as an asset on the employer's balance sheet.

But while these plans have many advantages, they also do have some drawbacks that prospective employers and participants should know about. Here is a list of the pros and cons of 401(k) plans.

Advantages of 401(k) Plans

  • Traditional 401(k) plans allow plan participants to defer a portion of their earnings on a pretax basis and defer taxation on plan distributions until retirement
  • Roth 401(k) plans allow participants to make after-tax contributions and take tax-free distributions until retirement
  • Plan participants can receive matching employer contributions that increase their plan balances over time and boost the rate of return that they get on their money
  • The money that is held inside a 401(k) plan is now exempt from seizure by creditors
  • 401(k) plans are portable. Employees can now roll their 401(k) plan from a previous employer into the 401(k) plan offered by their new employer, provided that the new plan accepts rollovers (which most do). Employees can also roll their plan into an IRA without incurring taxes.
  • Employees can often buy shares of company stock inside their 401(k) plans. Many employers also match their employees' contributions with shares of company stock instead of cash
  • When an employee retires, he or she can spin off all of the shares of company stock from the rest of their plan and sell them in a single special transaction that qualifies for capital gains treatment. This is done under the Net Unrealized Appreciation Rule (NUA)
  • Many employers offer a broad range of investments to choose from inside their plans, including stocks, bonds, mutual funds, annuities, guaranteed investment contracts and money market funds.
  • 401(k) plans are listed as an asset on the employer's balance sheet
  • 401(k) plans can serve as a tool to attract and retain quality employees, especially if the plan has a vesting schedule (see below)
  • Some 401(k) plans allow employees to take out a loan against their 401(k) balance up to a certain amount, such the lesser of 50% of the current plan balance or $50,000
  • 401(k) plans must be administered by a plan fiduciary, which means that the administrator must be careful to provide unbiased, high-quality service and administration of the plan

Disadvantages of 401(k) Plans

  • Plan administration can be expensive for employers, especially for smaller plans
  • Many plans charge participants an assortment of fees and expenses, such as administrative expenses that are levied on an annual basis.
  • Many investment choices, such as mutual funds and annuities, may also charge additional investment management fees that are levied on a monthly, quarterly or annual basis
  • Many variable annuities that are found in a large percentage of 401(k) plans can charge annual fees as high as 2-3%, after factoring in additional fees charged by the annuity on top of any plan fees
  • Any distribution taken from a 401(k) plan is taxed as ordinary income, which means that it will be taxed at the participant's top marginal tax rate
  • Any distribution that is taken before the participant is 59  ½ years old will be assessed a 10% early withdrawal penalty, unless a qualified exception applies
  • The investment choices inside a 401(k) plan are always preselected, so there is a limit on what a participant can invest their money in (although this is changing, as many plans now allow participants internal access to a full-service brokerage account)
  • Any unpaid loan amount from a 401(k) plan that is not repaid within 90 days of the employee leaving the company will be automatically coded as a regular distribution, with tax and possibly an early withdrawal penalty applying

401(k) Plan Management FAQs

What is a 401(k) plan?

A 401(k) plan is a retirement plan offered by an employer designed to help employees save for retirement.

What are 401(k) Plan Pros and Cons?

401(k) plans are employer sponsored, which often provides greater security in exchange for personalization. 401(k)s also only tax on withdrawal, which can be a pro or con depending on your tax bracket.

What is the difference between a Roth 401(k) and traditional 401(k)?

With a Roth 401(k), taxes are paid as money is put into the retirement account. With a traditional 401(k), taxes are paid as money is taken out.

Are there other retirement savings plans other than a 401(k) plan?

Alternatives to 401(k) plans include traditional IRAs, Roth IRAs, pension plans (if your employer offers one), and 403(b) retirement plans for employees of non-profit organizations.

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®), author of The Handy Financial Ratios Guide, 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.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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