Investing in a 401(k) plan may frustrate those who like to pick stocks. Employers may only offer a limited range of benefits, and most people can’t take money out of their 401(k) accounts before they turn 59½ without being charged a penalty.
People can avoid 401(k) restrictions by picking stocks and managing their own portfolios, but they miss out on tax breaks. According to a study by the Plan Sponsor Council of America, 98% of companies with a 401(k) plan offer matching contributions.
Are you torn between putting your hard-earned money into a 401k or buying individual stocks? This is a common dilemma many investors face, and the answer isn’t always straightforward. Let’s dive into this topic and help you make an informed decision that aligns with your financial goals.
The Short Answer
For most people, investing in a 401k is generally the better choice, especially if your employer offers matching contributions. However, the ideal strategy often involves a combination of both approaches. Here’s why.
Understanding 401k Plans
A 401k is an employer-sponsored retirement savings plan that offers several key advantages:
Tax Benefits
- Traditional 401k: Contributions reduce your current taxable income, and growth is tax-deferred until retirement
- Roth 401k: Contributions are made with after-tax dollars, but qualified withdrawals in retirement are tax-free
Contribution Limits (2024)
- Regular contribution limit: $23,000
- Additional catch-up contribution for those 50+: $7,500
- Total contribution limit (employee + employer): $69,000 ($76,500 with catch-up)
The Employer Match Advantage
One of the biggest perks of a 401k is the employer match – essentially free money! If your company offers to match, say, 3% of your salary when you contribute 3%, you’re getting an immediate 100% return on that portion of your investment before any market growth.
Investment Options
Most 401k plans offer a selection of
- Mutual funds
- Index funds
- Target-date funds
While these options might seem limited compared to the entire stock market, they typically provide built-in diversification across stocks, bonds, and other securities.
Understanding Direct Stock Investments
Buying individual stocks involves purchasing shares of specific companies through a brokerage account.
Potential Benefits
- Greater control over your investments
- Possibility of higher returns if you pick successful companies
- No contribution limits
- Better liquidity (access to your money without early withdrawal penalties)
Downsides
- Higher risk and volatility
- Requires more research and active management
- Less tax advantages compared to 401k
- No employer matching
- Capital gains taxes upon selling
Tax Implications
When you sell stocks for a profit:
- Short-term gains (held ≤1 year): Taxed at ordinary income rates
- Long-term gains (held >1 year): Taxed at preferential rates (0%, 15%, or 20% depending on income)
You also have to pay taxes on dividends, whether they are qualified dividends (tax rates are lower) or non-qualified dividends (tax rates are higher).
Key Comparison Factors
| Factor | 401k | Direct Stocks |
|---|---|---|
| Tax Benefits | Tax-deferred or tax-free growth | Taxed on gains and dividends |
| Employer Match | Available (free money) | Not available |
| Investment Options | Limited selection | Unlimited options |
| Risk | Generally lower due to diversification | Potentially higher |
| Liquidity | Limited until age 59½ | High liquidity |
| Control | Limited control over investments | Complete control |
| Contribution Limits | Yes ($23,000 in 2024) | No limits |
The Smart Strategy: Combining Both Approaches
Instead of choosing one over the other, many financial experts recommend a balanced approach:
-
First, contribute enough to your 401k to get the full employer match
This ensures you don’t leave free money on the table. -
Next, consider maxing out an IRA
IRAs offer more investment flexibility than most 401k plans. -
Then, either increase 401k contributions or invest in individual stocks
- If you’re risk-averse: Put more into your 401k
- If you’re comfortable with risk and enjoy researching companies: Consider individual stocks
Real Numbers: The Power of the 401k Match
Let’s look at a simple example:
If a person invested $2,000 a year in each option and their employer matched 3% of their contributions, their 401(k) balance would grow by 7% a year over five years, which is more than the value of their individual stock portfolio by $66,000!
When Stocks Might Be Better
Despite the advantages of a 401k, investing directly in stocks might make more sense if:
- You’ve already maxed out your 401k contributions
- You have poor investment options in your 401k (high fees, limited choices)
- You need access to funds before retirement age
- You have the knowledge and time to research individual companies
Common Questions
How much do I need in my 401k to generate $1,000 monthly?
The $1,000-a-month rule says that for every $240,000 you save in your retirement account, you can take out about $1,000 a month, with a 5% annual withdrawal rate.
Should I contribute to my 401k if there’s no employer match?
Yes, it’s still worth it because of the tax breaks, but you might want to work on maxing out an IRA first because they usually have more investment options.
Are 401ks still worth it?
Absolutely! Despite some drawbacks, 401ks remain valuable retirement tools due to their tax-deferred growth, potential employer matching, and compounding interest benefits over time.
What happens to my 401k if I leave my job?
You typically have several options:
- Keep it with your former employer (if allowed)
- Roll it over to your new employer’s plan
- Roll it over to an IRA
- Cash it out (not recommended due to taxes and penalties)
The Bottom Line
For most people, a 401k offers significant advantages over direct stock investments, particularly the employer match and tax benefits. However, the best strategy isn’t an either/or decision.
I recommend a balanced approach:
- Contribute enough to your 401k to get the full employer match
- If you still have money to invest, consider individual stocks for potentially higher returns
- Remember that your risk tolerance, time horizon, and financial goals should guide your decisions
The most important thing is to start investing now, regardless of which option you choose. Time in the market beats timing the market, and the sooner you begin, the more your money can grow through the magic of compounding.
The 401(k) Plan
Money invested in a traditional 401(k) is subtracted from pre-tax earnings. Delaying taxes until distribution keeps more money invested in an account during an individuals working years, which means greater earnings over time. People who put money into a Roth 401(k) pay taxes on their contributions right away, but they don’t have to pay taxes when they retire.
Employers commonly match a portion of an employees savings in a 401(k). For instance, an employer might put in $1 for every $1 that an employee puts in, up to 3 percent of their salary…. Nevertheless, investors can’t touch their 401(k) money until they reach age 59.02 without having to pay the income tax due plus a 2010 tax penalty. There are certain exceptions, such as disability.
Investment options can be limited to the choices an employer offers. These generally include a range of mutual funds, from conservative to aggressive funds. Individuals cannot predict their retirement tax rate, making it difficult to estimate how much money theyll have in their funds as they retire.
Employers may offer a target-date fund, an investment fund based on an investors retirement year, and rebalanced periodically to optimize returns over the long term as an individual reaches retirement age.
Stock-Picking
Individuals who invest on their own for retirement do not face penalties or have to meet any requirements for withdrawal. They also enjoy the freedom to invest in any financial vehicle. However, they forego the deferred tax advantages of a 401(k) plan combined with an employer match.
“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 an individuals skill as an investor. Making significant money over time stock-picking is risky and time-consuming to outperform the overall market. Many investors use index funds to simplify the process.
The amount a 401(k) balance would exceed an individual stock-pickers balance, assuming a $2,000-a-year investment in each with 3% employer matching and a 7% a year growth rate over 35 years.