401(k) Plan Vs. Stock-Picking: An Overview
Investing in a 401(k) plan may be frustrating to people who like to pick their own stocks. The available offerings through an employer can be limited. And, of course, there are restrictions on that 401(k). The biggest is that you can't touch the money until you're just shy of 60 without incurring a penalty.
But there are substantial advantages to a 401(k) plan that must be considered by anyone who is considering going solo on retirement investing. The tax benefits are substantial. In addition, almost half of employers match some portion of their employees' contribution to a 401k. The median for the match is 3% of the employee contribution.
The 401(k) sometimes gets a bad rap. Financial gurus complain that it’s a poor replacement for a pension plan and that there may be better options for investing your money. But is investing on your own one of those better options? Let’s compare the two.
- A 401(k) contribution is based on pre-tax income, lowering the individual's immediate tax bill.
- Taxes on the money is delayed until it is withdrawn, boosting the 401(k) balance over time.
- About half of employers contribute to their employees' 401(k) plans, with a median match of 3%.
The 401(k) Plan
First, a 401(k) comes with tax advantages. The money invested is subtracted from pretax earnings. Thus, about one-third of an annual $2,000 contribution is effectively canceled out by the immediate income tax savings the employee enjoys.
The capital gains on the money are tax-free until the money is withdrawn or, to use the government lingo, until distributions are made. Delaying taxes until distribution keeps more money invested in your account during your working years, and that equals greater earnings over time. In addition, roughly half of companies that offer 401(k) plans make a matching contribution. It’s hard to say no to free money.
But with every advantage comes a tradeoff. You can’t touch 401(k) money until you reach age 59½ without paying the income tax due plus a 10% tax penalty. (There are certain exceptions such as a disability.)
The amount a 401(k) balance would exceed an individual stock-picker's balance, assuming a $2,000 a year investment and a 7% a year growth rate over 35 years.
Your investment options are limited to the choices your employer offers. These generally include a wide enough range of mutual funds, from very conservative to very aggressive funds, to satisfy most investors. Your employer may even offer a self-directed option where you can manage all or a portion of your funds on your own.
Finally, no one can predict what the tax rate will be when you retire. That makes it difficult to estimate just how much money you'll have to retire on. (If a Roth 401(k) is available to you, consider that option. You pay the income taxes up front and pay no taxes on the gains when you withdraw the money.)
Many of us have major financial goals that aren't related to retirement: A down payment on a house or a college education, for instance.
That makes investing on your own seem like an attractive option. The money in your account is available at any time for any purpose. There are no 10% penalties, and you don’t have to meet any requirements for withdrawal.
If a Roth 401(k) is available to you, consider that option. You'll pay the income taxes up front and pay no taxes on the gains when you withdraw the money.
You also get the freedom to invest in anything you want. But that doesn't make it the better choice. For starters, there’s no company match for the money you invest on your own.
The tax advantages of a 401(k) plan combined with an employer match are a winning combination. If you invested $2,000 a year over 35 years, assuming a 7% per year growth rate, a 401(k) with a 3% employer match would earn about $66,000 more than a brokerage account.
“If you invest your retirement directly into stocks instead of a retirement account, you will be subject to taxes on the dividends and capital gains when you sell the stocks. You also have the variability of stock price performance that may require you to sell at an inopportune time. While you may want to buy and hold, the economic outlook may change, requiring you to sell and realize capital gains,” explains Kirk Chisholm, a wealth manager at Innovative Advisory Group in Lexington, Mass.
There’s also the matter of your skill as an investor. Making significant money over time as a stock-picker is extremely difficult. Even the pros have trouble outperforming the overall market. That's why index funds are so popular.
For most people, the 401(k) is the better choice, even if the available investment options are less than ideal. For best results, you might stick with index funds that have low management fees.
If you have money to invest above the amount that is matched by your employer, you might consider investing it on your own.