The 401(k) plan for retirement savings came along at a time when the traditional employer-provided pension was on its way out. It helped Americans save for the future for decades. But recent shifts in the economy have put Americans’ retirement savings in crisis.
How the 401(k) plan came to be
In 1979, benefits consultant Ted Benna noticed that the rules established in the Revenue Act of 1978 made it possible for employers to establish simple, tax-advantaged savings accounts for their employees. Benna designed the original 401(k) plan for a bank client seeking to give employees additional retirement benefits. However, the bank rejected the idea because it had never been done before, so Benna offered the first 401(k) plan to his own employees at The Johnson Companies.
By 1981, the IRS had proposed formal rules for 401(k) plans. In1982, several large companies began to offer new 401(k) plans to employees. Participants in the plans could then use their deferred income to make investments without being taxed on gains. These new accounts quickly became popular. According to 401GO, 7.1 million employees participated in a 401(k) plan in 1983, a number that grew to 38.9 million by 1993. As of 2019, 401(k) plans covered an estimated 80 million people and held $5.7 trillion in assets.
It is incredibly simple to participate in an employer’s 401(k) plan; all you have to do is opt in to a payroll deduction. These 401(k) accounts have offered Americans an easy, effective avenue for saving part of their earnings for retirement. And, when employers offer a matching contribution, it gives employees an instant boost to those savings. The accounts were designed with the longer term in mind.
The plan’s rather unprovocative name, “401(k),” refers to Section 401(k) of the Internal Revenue Code.
There is a limit to the amount of money you can set aside for retirement in a 401(k) plan. For 2023, the 401(k) limit for employee salary deferrals is $22,500, an increase from the 2022 limit of $20,500. Employer matches don’t count toward this limit and can be quite generous. The total contribution limit, which includes employer contributions (and after-tax contributions, if your employer offers that feature), increased to $66,000 in 2023, up from $61,000 in 2022. On top of these amounts, workers aged 50 and older can add up to $7,500 more annually as a catch-up contribution in 2023, up from $6,500 in 2022.
However, recent shifts in the American economy and workforce have led to some unfortunate trends in 401(k) savings. Let’s explore why the 401(k) concept seems to be in trouble.
Americans have left the workforce in droves
First, during the COVID-19 pandemic, an unprecedented number of Americans left their jobs. In 2021, according to the U.S. Bureau of Labor Statistics, more than 47 million Americans voluntarily quit their jobs. And, according to the U.S. Chamber of Commerce, there are almost two million fewer Americans participating in the labor force today than there were in February 2020.
Now, there are ideal strategies for people who have left companies, if they had 401(k) accounts with those employers: 1) leave their accounts with their employers, 2) move their accounts over to the new employer or 3) roll their accounts over into an individual retirement account (IRA).
However, many of those people who left their employers and stayed out of the workforce cashed out their 401(k) accounts, which should always be a last resort. A 2022 Fidelity study found that 21 percent of Americans who left their jobs cashed out their 401(k) plans.
Cashing out a 401(k) before age 59½ can cost you more than 40 percent of your retirement savings because penalties are assessed for early withdrawal. Plus, there are likely tax implications, and you halt your progress toward saving for retirement because you’re no longer contributing. You also lose future growth on those contributions over time.
And many never went back
Today, even though the pandemic has subsided, many people have stayed out of the workforce.
When the U.S. Chamber of Commerce surveyed people who have not rejoined the workforce to ask why, 27 percent said they need to be home to care for children or other family members. More than one-fourth (28 percent) said they have been ill and their health has taken priority over looking for work. Other reasons people gave were that they are still concerned about COVID-19 at work, pay is too low and people are now focused on acquiring new skills and education before re-entering the job market.
A large number of workers decided to start their own businesses. Given a rise in the gig economy, plus a new trend in job hopping, people are facing a new retirement crisis: the combination of tax bills due now and slimmer nest eggs later. This phenomenon is happening most frequently among millennials, the largest adult generation, according to Fidelity Investments.
Inflation has people focusing on the present
High inflation has contributed to the 401(k) crisis, too. As the cost of living climbs, more Americans have been cashing out their retirement accounts to pay not just for financial emergencies but for everyday living expenses.
Taking a hardship withdrawal from a 401(k) account results in high penalties, just as cashing out completely does. In the first three months of 2023, Bank of America found that the number of people taking hardship withdrawals jumped 33 percent from the same period a year earlier, with workers taking out an average of $5,100 each. Fidelity found that 2.4 percent of 22 million people with retirement accounts in its system took hardship withdrawals in the final quarter of 2022, up half a percentage point from a year earlier. A similar analysis by Vanguard found that 2.8 percent of five million people with retirement accounts made a hardship withdrawal last year, up from 2.1 percent a year earlier.
During the pandemic, the personal savings rate hit a high of nearly 34 percent in April 2020 because of Covid lockdowns and stimulus payments. But more recently, the personal savings rate has fallen to about 5 percent, according to the U.S. Bureau of Economic Analysis.
One reason for the decline is the CARES Act, which temporarily relaxed restrictions around hardship withdrawals in 2020, triggered an increase in withdrawals from retirement accounts. The government’s intentions may have been in the right place, but the legislation made it easier for people to tap into funds that were earmarked for the future.
The economic downturn has eaten into retirement savings
In 1922, the S&P 500 tumbled 19.4 percent and entered the longest bear market since the 2008 financial crisis. The downturn has marked a sharp departure from the prior decade, when a bull market boosted investment portfolios and appeared to place a comfortable retirement within reach for many workers.
As a result, the ranks of America’s “401(k) millionaires” have diminished. The number of 401(k) accounts with at least $1 million in retirement savings fell 32 percent in 2022, to 299,000, from 442,000 in 2021, according to Fidelity Investments. The average balance in a 401(k) plan decreased 20.5 percent in 2022, reducing the typical employee nest egg to $103,900 by the end of 2022.
Ways to save for retirement beyond the 401(k)
Trends in the financial profession change. The state of the economy changes. Your personal circumstances and goals change. But it’s critical to keep up with your retirement savings, regardless of what’s going on in the world around you and beyond.
If you no longer work for an employer, please make it a priority to establish a new way to save for retirement on your own. Or, if you are not happy with your current employer’s plan, you need to look at alternatives. Maybe your employer doesn’t offer a matching contribution to its 401(k) plan. Or maybe it offers limited investment options or charges higher-than-average fees for the options provided.
Whatever your reason for seeking out alternatives, you have options. I strongly recommend that you meet with your financial advisor to explore these options and choose the one that is ideal for your unique situation, needs and goals.
Here are just four of many alternatives to consider. There are pros and cons to each option, so again, please discuss these and other strategies with your advisor.
1. Traditional IRA
With a traditional individual retirement account, your money grows tax-deferred. You won’t pay taxes on it until you withdraw it once you retire. Also, you might be able to deduct contributions you make to the account from your taxable income, which enables you to defer paying taxes on that income.
As with many retirement-savings programs, there are annual limits on the amount you can contribute to a traditional IRA. In 2023, the limit is $6,500 for those under age 50 and $7,500 for those age 50 and older. Also, you will have to take out required minimum distributions (RMDs) when you reach a certain age.
2. Roth IRA
A Roth IRA differs from a traditional IRA in that you won’t get any immediate tax savings. However, you can grow your money tax-free, and you can withdraw any or all of your money once you retire, completely tax-free. Other benefits are that you can withdraw your contributions at any time without paying a penalty, you won’t pay capital gains on asset sales and you can transfer your account balance to heirs.
There are annual limits on Roth IRAs as well. Plus, there are income limits, so if you make too much money, you won’t be able to take advantage of this option.
3. SEP IRA
This is a great option for the self-employed who have joined the gig economy. If you have income as a freelancer or from a side job, or if you own a business, you can set money aside for retirement in a SEP IRA. One key difference with this plan is that the contribution cap is much higher than it is with IRAs. In 2023, you can contribute up to $66,000 or 25 percent of your eligible compensation, whichever is less. However, you cannot contribute more than 25 percent of your business earnings.
4. Taxable investment accounts
Another alternative to consider is a taxable investment account — that is, a non-retirement account or brokerage account. You won’t get any tax advantages such as deductible contributions or tax-free growth. However, it is possible you could earn better returns than you would by keeping your money in a regular savings account. Talk with your advisor about your risk profile and time horizon because these are key factors in determining to what extent this would be an appropriate option for you.
This option offers a lot of flexibility. You can invest as little or as much as you like in a taxable account and put your money into stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs) and other options. Earnings from these investments are subject to capital gains taxes. Your advisor can guide you in determining how that might affect your retirement.
If you once relied on a 401(k) plan to save for retirement, but that’s no longer an option, for whatever reason, please make it a top priority to begin saving in a different type of account.
As you are working with your advisor on the type of plan that’s appropriate for you, also prioritize building up your emergency fund. Many of the people who cashed out their 401(k) plans during the pandemic did so to cover unexpected expenses over a long period of time. Your emergency fund is your buffer from the unexpected. It can help you avoid having to deplete the money you’ve saved for the future to sustain you and your family today.
In the end, the goal is to balance providing for your current needs with saving for the future. That takes planning, commitment and a solid plan. Planning can avert a crisis!
Any opinions are those of the author and not necessarily those of Raymond James. This material is being provided for informational purposes only and is not a complete description, nor is it a recommendation. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk, and you may incur a profit or a loss, regardless of strategy selected. Past performance is no guarantee of future results. Prior to making an investment decision, please consult with your financial advisor about your individual situation.