Key Takeaways:

1. Investment expenses will include fund expense ratios and can also include investment management and custodial expenses. These costs can have a direct impact on how much each employee, including owners, can build for retirement. The goal for a small business, or any business, is to keep all-in fees under 1% for employees. If you can get a fund line-up made of all or mostly index funds, you will likely be well ahead of most plans.
2. Ensure that the financial experts you are consulting with are licensed, 401(k) fiduciaries. They have a legal responsibility to make investment decisions in your best interests, and do not stand to make commission or fund revenue sharing off the investments they select for your plan’s investment roster. They will have a clear investment management charge that should decrease as your plan assets grow.
3. Traditional, “pre-tax” contributions reduce your personal current taxable income in the current year but will be taxed upon withdrawal in retirement.
4. Roth, “post-tax” contributions provide tax-free withdrawals in retirement, including both contributions and investment gains.
5. Profit-sharing and employee 401(k) matching are tax deductible for your business. Tax credits of up to $15,000 over three years are available for new businesses starting a 401(k) with less than 100 employees.
6. 401(k) withdrawal fees can be avoided if assets are withdrawn after age 59 ½ and RMDs are regularly taken out after age 73. Roth 401(k) contributions are not subject to RMDs.
7. 401(k)s are likely the most tax advantaged way to save for retirement due to automated investing with each payroll, low investment costs and features such as 401(k) loans, profit-sharing, and 401(k) matching for employees.

In this day of technology, you can find a lot of opinions floating on the web about how you should save for retirement. You might have heard some so-called “experts” express their skepticism for 401(k)s. Some say they’re costly, some say it’s all a big gamble, some say the government will tax you more on your 401(k). False, false, false! In fact, some even say it’s not your money. It is your money! Bottom line, these “experts” believe 401(k)s are a scam. Well, are 401(k)s a scam?

Spoiler alert – of course 401(k)s are not a scam. In fact, the United States Federal Reserve Board’s latest report on consumer finances shows that that the two key drivers of American wealth are their house and their retirement account (see page 17 for more on retirement accounts).

And like any financial decision, it is important to do your research and understand where your money is going. Again, 401(k)s are not a scam. 401(k)s are actually one of the best ways to save money for your future and take advantage of the multiple perks including automatic contributions, company matches, tax saving incentives, and more. But let’s break down 3 common myths about 401(k)s so you can debunk any nay-sayers and keep on the path to saving for retirement.

Myth #1—Your Money Will Be Wasted on Fees

This first point is not all myth. 401(k)s providers do include fees to offset the cost of managing the 401(k) plan. However, if you play it smart, there are means to mitigate costs. Let’s look at what fees are included in a 401(k) plan and how to avoid being overcharged.

What Fees Are Associated with a 401(k)?

Typically, 401(k) fees include recordkeeping, administrative, and investment expenses, but if providers are not upfront about how these costs and fees are assessed, you could be hit with other expenses including some that vary by fund. Your participants may even be charged a flat monthly participation fee pulled directly from their 401(k) monies that will impact the return of their investment over time.

How Can You Minimize 401(k) Costs?

When considering a 401(k) provider, make sure the 401(k) plan has the employer cover all the recordkeeping and admin costs. These don’t tend to be that much and not only will your employees thank you as the plan sponsor, but these costs are tax deductible for your business. Better yet, small businesses starting a new plan will receive tax credits in addition to deductions to cover admin costs for the first three years of the plan.

When it comes to investment expenses, look for those that offer a flat investment management expense across the plan to manage roster selections with ERISA 3(38) services, plan consultation, employee education, and custodial services. If the plan is large enough, investment expenses can cover admin costs altogether. What you probably want to avoid is a fund line-up that has a preponderance of actively managed mutual funds or insurance options with fund expense ratios greater than 0.75% (over 1% is a definite red flag).

In general, the tax deferral advantages of a 401(k) generally far outweigh the costs associated with the plan, especially compared to a retail investment account. With those accounts, you’ll typically pay taxes on dividends and even pay capital gains for switching investment funds. Dividends and capital gains are not taxed in a 401(k). In fact, 401(k)s allow you to maximize tax deferred savings as you are able to contribute and receive employer matching to $69,000 per year (for 2024) into your 401(k), which is much higher than the IRA contribution limit of $7,000.

A good rule of thumb when considering 401(k) fees is to keep all-in expenses under 1%. This includes the administrative fees paid to the provider to manage your plan, as well as the investment expenses that come with investing the plan assets. If a 401(k) plan is offering anything over this 1%, consider seeking an alternative solution. A 1% added expense may not seem significant at first, but compounded over a 30- or 40-year career time can cost you a lot of money.

What Should You Avoid?

Most of these so called “experts” claiming that 401(k)s are a scam are typically pushing for annuities, universal life insurance policies, or other types of savings accounts, as they’ll stand to earn a commission. They tend to be very expensive too. You’ll never hear them dive into the risks and fees. In fact, annuities typically have fees upwards of 2-3% annually, way above the <1% recommendation, and life insurance policies can have premiums that could increase every year. Be smart and go with a retirement advisor that has your best interests at heart.

Myth #2—Your Hard-Earned Retirement Money is Going to Be Gambled Away

401(k)s, like other investment savings vehicles, are made to help your money grow over time. In order for the money to grow, the assets need to be invested in the market in some way, and markets do have some inherent risk. However, 401(k)s are specifically a retirement account, so the money will generally have many, many years to compound prior to you withdrawing the funds. When selecting your investments, it's important to consider your risk tolerance and investment time horizon to ensure you're properly invested based upon your goals.

What is a Fiduciary and How Do They Help You Save?

401(k) regulations require some sound investing requirements. 401(k) investment fund line-ups are designed to be diversified to help minimize against large loss. The selection of the fund line-up is the responsibility of the employer or the advisor they employ. The people determining the line-up are held to an expert standard. The aim is to provide you with a select group of funds to invest in to help you reach your goals no matter your time horizon or risk aversion. These people are called fiduciaries, and they are legally required to make decisions that are in your best interest.

Most business owners are not financial experts, so they will need one to help manage their 401(k) benefits offering. When considering a financial “advisor” or “consultant," it is important to choose someone that is a fiduciary. If they are not a registered fiduciary (ERISA 3(38) advisor), they are not required to make unbiased investment selections and financial decisions that directly benefit you. “Consultants” or “advisors” who are not fiduciaries stand to make commissions off or revenue pass-through fees from the funds they choose to invest in with your money and are incentivized to make financial choices that may be worse for you. It’s why you often see few, if any, index funds in their fund rosters and most index funds have no pass-through fees.

A quality 401(k) fiduciary will put together an investment fund line-up with the goal of growing your money over time, minimizing investment costs, and is in line with 401(k) regulations. You can expect to have model portfolios designed for different risk tolerances. For example, a young person who is just starting to save for retirement may choose a growth or aggressive portfolio since they have more time to ride the waves of the market, while an older person may choose a stable or conservative portfolio as they reach closer to retirement age. Model portfolios can be a great fit for less experienced investors or those that don’t have the time to research individual fund options. But of course, there will be a roster of funds by asset class for more experienced team members.

Mutual Funds or Exchange-Traded Funds (ETFs)?

Whether you choose a model portfolio or pick your own investments, you’ll need to consider the type of funds you decide to invest in. You may have heard that there are mutual funds and exchange-traded funds. The majority of mutual funds are actively managed funds, meaning they are typically managed by a fund manager who makes decisions to sell stocks or securities to try to beat the market in a specific asset class or sub-class. Unfortunately, these funds tend to incur much higher expenses than an index fund, as they require more managers, research, and other costs to oversee the fund.

Higher investment costs are tough to overcome as each dollar that goes to expenses is one less dollar invested in the market and predicting the markets is pretty much impossible. This is why, historically, very few actively managed funds outperform index funds over a 5 or more-year period. Index funds, which include most all exchange-traded funds (ETFs), are a collection of stocks, bonds, or commodities that typically track a market index such as the S&P 500 or the Dow Jones Industrial Average. As you can see the chart below, index funds have historically outperformed most actively managed mutual funds over the long-term.

10-Year Performance of Actively Managed Funds Versus Benchmark Indices

*Source: SPIVA (Standard and Poor's Indices Versus Active Funds) U.S. Scorecard. End of Year 2023, S&P Dow Jones Indices LLC. Past performance is no guarantee of future results.

There is always risk to investing in the market, but with a 401(k) plan, the monies invested are done so for the long-term, and have more opportunity to grow over time with the right, low-expense investment strategy. Whether your business chooses to manage your investment roster, or have an investment fiduciary do the work, it is important to make sure your fund roster is chosen wisely. Historical data and expense ratios can be a major factor with determining fund allocations, so if you do your research, more of your money will stay invested with a greater opportunity for growth.

Myth #3—The Government is Going to Take a Lot in Taxes

When some hear the term “401(k)," they immediately think about the government, as the 401(k) is part of a government regulation enacted to help folks save for retirement. And while it is good that the government brought forth a retirement savings plan to help employers and employees alike, there is always the question of how much will be owed back come tax season. The last myth that tends to be circulated around is that the government is going to take most of your hard-earned retirement money in taxes—and there is nothing you can do about it. In fact, 401(k)s are designed to help you save on taxes as
they are accounts that use tax incentives to help more employees choose to contribute for retirement.

401(k)s Are a Tax Savings Vehicle

401(k)s, first and foremost, are a tax savings vehicle, meaning you can use your 401(k) to actually save on taxes that would otherwise be owed to the government. Tax advantaged accounts like a 401(k) or IRA help you avoid taxes on dividends and capital gains too. You can also contribute to your 401(k) in two different ways to help you save on taxes—with a Roth 401(k) or a Traditional 401(k).

Tax Benefits of a Roth 401(k)

A Roth 401(k) enables business owners and employees to make after-tax contributions with no income level restrictions – unlike the Roth IRA which has income limits. This means that employees that use the Roth 401(k) option will have the advantage of tax-free withdrawals – earnings and all – when they use these funds in retirement. Owners and employees can choose to put all, part, or none of their personal contributions into their Roth. These contributions are taxed at your current tax bracket.

You can also put more money away towards your Roth 401(k) than a Roth IRA. For 2024, you can contribute your employee elective contributions up to the $23,000 limit ($30,500 if age 50 or older) vs only $7,000 with the Roth IRA. The more you put away now post-tax, the more you can take out tax-free at retirement. Many financial advisors suggest saving 10-15%¹ of your income over your career for a comfortable retirement. This is a great option for those who don’t mind having a little less take-home pay per paycheck, and for investors who may eventually move up in tax brackets and want to avoid being taxed at that level later in life.

Tax Benefits of a Traditional 401(k)

Traditional 401(k) contributions are made pre-tax or tax deferred, which means contributions made before your income is subject to taxation. This means that the amount you contribute to your 401(k) is deducted from your taxable income, reducing the income you report on your annual tax return for the current year. As a result, you pay less in income taxes in the year you make the contribution. However, it's important to note that you will pay taxes on your withdrawals during retirement.

For traditional 401(k)s, the money you withdraw (also called a “distribution”) is taxable as regular income in the year you take it. The rate at which your distributions are taxed will depend on how much you withdraw and which federal tax bracket you're in at the time of your qualified withdrawal. Many people have lower income in the first few years of retirement compared to the last five or ten years preceding retirement. If you are fortunate and your tax bracket is higher at the time of retirement, keep in mind that US tax rates are marginal, meaning that each tax rate applies only on the amount of your income that falls into that certain range. For instance, the bottom tax rate of 10% applies to all income between $0 and $11,600. If you were to make $12,000 that year, $11,600 of it would be taxed at the 10% rate, and $400 would be taxed at the rate of the next tax bracket (12%).

If you are unsure whether it would be best to contribute pre-tax (traditional) or post-tax (Roth), a common strategy is to divide your contributions between the two. This allows you to “hedge your bets” and provides you an extra option on how to use your savings when you reach retirement age. For instance, you can take money out of the Roth portion of your account in years when you need to spend more money to keep taxes in check and use the traditional 401(k) monies at times when your spending will be lower.

So, while many scammers throw around claims that the government is going to take 30-40% of your retirement savings when you go to make a withdrawal, as you can see, 401(k)s are a great tool to keep your personal taxes in check in retirement.

Your Business Can Save on Taxes with a 401(k)

Tax Credits and Profit Sharing

Businesses with at least one employee (in addition to the owner) and up to 100 employees qualify for an annual tax credit to offset plan administrative costs for the first three years. Those with 1-50 employees are allowed to offset 100% of these costs with the credit and can save $5,000, for a potential cumulative savings of $15,000 over the three years. Most small business 401(k)s won’t cost nearly this much. Businesses with 51-100 employees can receive half that, or $2,500 for one year and $7,500 for three years.

Administrative costs will vary by the number of employees that participate in your plan. For a business with 10 employees just starting their first retirement plan, expect to pay about $1,200 a year. Subtract the credit that covers 100%, and your administration drops to $0 per year! Additionally, if you choose an automatic enrollment feature with auto-escalation, you qualify for another $500 per year for the first three years.

Another option to save on taxes for your business is to offer profit-sharing contributions to employees' 401(k) accounts. 401(k) profit sharing allows employers to give employees (including owners) a discretionary contribution. The profit share contribution is typically 100% tax deductible, which can help businesses lower taxes versus other profit-sharing options. If you contribute $100,000 in profit sharing, you likely reduced your businesses' taxable income by $100,000. The profit share also isn’t subject to Social Security or Medicare withholdings.

Employers can contribute up to 25% of an employee’s income up to the limit into their 401(k) and qualify for it to be 100% tax deductible for the business. The maximum amount an employee can receive for 2024 in a 401(k) account is $69,000 ($76,500 if 50+ years of age) including their own personal contributions.

401(k) Matching Can Qualify for Tax Credits and is Tax Deductible

For a business, employer contributions are optional in 401(k) plans. But without a match or other employer contribution, it can limit how much highly compensated employees (including owners) can put into their 401(k) account. The good thing is that by providing a relatively small match to eligible employees, you can maximize your contributions. For small businesses starting their first plan, you can qualify for tax credits to offset matching for the first three years. In addition, employer contributions not covered by the credit as well as ongoing are often a 100% tax-deductible expense for your business, too.

Other Ways to Avoid and Minimize Taxes with Your 401(k)

Avoid Early Withdrawals

If you contribute to your 401(k) tax deferred, you’ll need to pay the income tax owed when you withdraw it in retirement just like an IRA. However, tax deferred retirement accounts have an age withdrawal requirement of 59 1/2, and if you decide to withdraw funds early, you will pay a 10% tax penalty, on top of any income tax owed. Retirement accounts are designed to be used later in life and that's why there are tax incentives to save through your career and this tax disincentive to withdraw money early.

The simple solution here would be to avoid withdrawing monies from your 401(k) until you reach age 59 1/2. This money is intended for retirement anyway, so it is important to leave your assets alone and let them grow for later use. However, if you find yourself in a situation where you do need access to your 401(k) funds, many plans allow you to take out an 401(k) loan instead. This avoids all tax penalties and you pay yourself back into your 401(k) account generally over a 5-year period. It is designed for emergency needs, so keep that in mind.

Know the RMD Requirements

Additionally, you don’t even have to start taking distributions from your 401(k) at age 59 ½. You can continue to contribute to your 401(k) tax-deferred (which will help you save on income taxes) or after tax with the Roth, and the 401(k) will continue to invest and compound. In addition, you can also contribute even more upon reaching 50 years of age with catch-up contributions (these raise the individual 401(k) contribution limit from $23,000 to $30,500 and the most you can receive annually with employer contributions is up to $77,500 from $69,000 for 2024). That is a lot in savings!

You can contribute and let your money grow undisturbed until age 73, unless you are still working. If you are retired, you’ll be required to take out annual distributions, known as Required Minimum Distributions (RMDs). There is a hefty penalty for not taking an RMD on time, and that is generally 10%-25% of the amount not taken by the deadline. Consult with your financial advisor if you are confused about how much you’ll need to take in an RMD and avoid the penalty.

If much of your retirement savings are in a Roth 401(k), congratulations! You have already paid your share of taxes to the government and can withdraw your money (after age 59 ½ and holding the account for 5 or more years) penalty free. Starting in 2024, monies in a Roth account are not subject to RMDs, so they can continue to live in the Roth 401(k) until the death of the owner. At that point, beneficiaries of the account would be subject to RMD rules.

While there are government penalties that could possibly put a dent in your retirement money, you can easily safeguard yourself against these penalties by staying informed and following the rules of your 401(k) account.

Tax Advantaged Funds Avoid Dividends and Capital Gains Tax

Funds in a 401(k) are exempt from dividends and capital gains tax. You won’t be taxed on your investments as your 401(k) grows each year as long as your money remains in the account and no withdrawals are made. Again, this is a great advantage over retail investment accounts, where you will be required to pay taxes on dividends or capital gains each year.

As you look for new ways to pay yourself more and keep taxes in check for your business, know that your 401(k) can be a big help. To ensure maximum tax benefits, the earlier you start the better. The savings benefits might just last you a lifetime. It’s always wise to check with your tax advisor for more insights and strategies for your specific situation.

401(k)s Are the Superior Way of Saving for Retirement

Don’t let the nay-sayers fool you. 401(k)s are a powerful saving opportunity for retirement. You can set up your 401(k) and forget it—automatic withdrawals from each paycheck allow you to contribute to your 401(k) with ease. Investment model portfolios and low-cost investment funds help your money grow over time while paying less in expenses. And don’t forget the added features of emergency penalty-free loans, 401(k) matching for employer tax savings and free money for employees and owners.

Like with many forms of investing, 401(k)s do have rules to abide by, but if you do your homework and consult the experts, you can set your 401(k) up for success and build a nice nest egg for your retirement. If you listen to what the scammers say on social media, you may be tricked into going with investment strategies that will cost you more in the long run and have limited benefits. As you can see, when you have the facts, these jokesters saying 401(k) are a scam are actually the scammers.

¹Industry experts generally agree that, depending on when you begin contributing, a minimum contribution of 10-15%, will be necessary to reach a goal of 8 to 10 times your ending annual salary prior to retirement. You may want to review your current contribution level to determine whether you believe it is sufficient to meet your retirement goals. There is no guarantee that contributions at this level will result in sufficient funds to meet those goals.

This material is intended only as general information for your convenience and should not in any way be construed as investment or tax advice by ShareBuilder 401k. The owner/participant should consult with their tax advisor regarding any specific tax strategies.

Past performance is not an indication of future results. The value of your investment will fluctuate over time and it is possible to lose part or all of the amount invested.