Tax Advantages

The average rate of return on 401(k)s is typically between 5% and 8%, depending on specific market conditions in a given year. Keep in mind that returns will vary depending on the individual investor’s portfolio, and that those numbers are a general benchmark.

While not everyone has access to a 401(k) plan, those who do may wonder if it’s an effective investment vehicle that can help them reach their goals. The answer is, generally, yes, but there are a lot of things to take into consideration. There are also alternatives out there, too.

Some 401(k) Basics

To understand what a 401(k) has to offer, it helps to know exactly what it is. The IRS defines a 401(k) as “a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts.”

In other words, employees can choose to delegate a portion of their pay to an investment account set up through their employer. Because participants put the money from their paychecks into their 401(k) account on a pre-tax basis, those contributions reduce their annual taxable income.

Taxes on the contributions and their growth in a 401(k) account are deferred until the money is withdrawn (unless it’s an after-tax Roth 401(k)).

A 401(k) is a “defined-contribution” plan, which means the participant’s balance is determined by regular contributions made to the plan and by the performance of the investments the participant chooses.

This is different from a “defined-benefit” plan, or pension. A defined-benefit plan guarantees the employee a defined monthly income in retirement, putting any investment risk on the plan provider rather than the employee.

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Benefits of a 401(k)

There are a lot of benefits that come with a 401(k) account, and some good reasons to consider using one to save for retirement.

Potential Employer Match

Employers aren’t required to make contributions to employee 401(k) plans, but many do. Typically, an employer might offer to match a certain percentage of an employee’s contributions.

Tax Advantages

As mentioned, most 401(k)s are tax-deferred. This means that the full amount of the contributions can be invested until you’re ready to withdraw funds. And you may be in a lower tax bracket when you do start withdrawing and have to pay taxes on your withdrawals.

Federal Protections

One of the less-talked about benefits of 401(k) plans is that they’re protected by federal law. The Employee Retirement Security Act of 1974 (ERISA) sets minimum standards for any employers that set up retirement plans and for the administrators who manage them.

Those protections include a claims and appeals process to make sure employees get the benefits they have coming. Those include the right to sue for benefits and breaches of fiduciary duty if the plan is mismanaged, that certain benefits are paid if the participant becomes unemployed, and that plan features and funding are properly disclosed. ERISA-qualified accounts are also protected from creditors.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

401(k) Fees, Vesting, and Penalties

There can be some downsides for some 401(k) investors as well. It’s a good idea to be aware of them before you decide whether to open an account.

Fees

The typical 401(k) plan charges a fee of around 1% of assets under management. That means an investor who has $100,000 in a 401(k) could pay $1,000 or more. And as that participant’s savings grow over the years, the fees could add up to thousands of dollars.

Fees eat into your returns and make saving harder — and there are companies that don’t charge management fees on their investment accounts. If you’re unsure about what you’re paying, you should be able to find out from your plan provider or your employer’s HR department, or you can do your own research on various 401(k) plans.

Vesting

Although any contributions you make belong to you 100% from the get-go, that may not be true for your employer’s contributions. In some cases, a vesting schedule may dictate the degree of ownership you have of the money your employer puts in your account.

Early Withdrawal Penalties

Don’t forget, when you start withdrawing retirement funds, some of the money in your tax-deferred retirement account will finally go toward taxes. That means it’s in Uncle Sam’s interest to keep your 401(k) savings growing.

So, if you decide to take money out of a 401(k) account before age 59 ½, in addition to any other taxes due when there’s a withdrawal, you’ll usually have to pay a 10% penalty. (Although there are some exceptions.) And at age 73, you’re required to take minimum distributions from your tax-deferred retirement accounts.

Potentially Limited Investment Options

One more thing to consider when you think about signing up for a 401(k) is what kind of investing you’d like to do. Employers are required to offer at least three basic options: a stock investment option, a bond option, and cash or stable value option. Many offer more than that minimum, but they stick mostly to mutual funds. That’s meant to streamline the decision-making. But if you’re looking to diversify outside the basic asset classes, it can be limiting.

How Do 401(k) Returns Hold Up?

Life might be easier if we could know the average rate of return to expect from a 401(k). But the unsatisfying answer is that it depends.

Several factors contribute to overall performance, including the investments your particular plan offers you to choose from and the individual portfolio you create. And of course, it also depends on what the market is doing from day to day and year to year.

Despite the many variables, you may often hear an annual return that ranges from 5% to 8% cited as what you can expect. But that doesn’t mean an investor will always be in that range. Sometimes you may have double-digit returns. Sometimes your return might drop down to negative numbers.

Issues With Looking Up Average Returns As a Metric

It’s good to keep in mind, too, that looking up average returns can create some issues. Specifically, averages don’t often tell the whole story, and can skew a data set. For instance, if a billionaire walks into a diner with five other people, on average, every single person in the diner would probably be a multi-millionaire — though that wouldn’t necessarily be true.

It can be a good idea to do some reading about averages and medians, and try to determine whether aiming for an average return is feasible or realistic in a given circumstance.

Some Common Approaches to 401(k) Investing

There are many different ways to manage your 401(k) account, and none of them comes with a guaranteed return. But here are a few popular strategies.

60/40 Asset Allocation

One technique sometimes used to try to maintain balance in a portfolio as the market fluctuates is a basic 60/40 mix. That means the account allocates 60% to equities (stocks) and 40% to bonds. The intention is to minimize risk while generating a consistent rate of return over time — even when the market is experiencing periods of volatility.

Target-Date Funds

As a retirement plan participant, you can figure out your preferred mix of investments on your own, with the help of a financial advisor, or by opting for a target-date fund — a mutual fund that bases asset allocations on when you expect to retire.

A 2050 target-date fund will likely be more aggressive. It might have more stocks than bonds, and it will typically have a higher rate of return. A 2025 target-date fund will lean more toward safety. It will likely be designed to protect an investor who’s nearer to retirement, so it might be invested mostly in bonds. (Again, the actual returns an investor will see may be affected by the whims of the market.)

Most 401(k) plans offer target-date funds, and they make investing easy for hands-off investors. But if that’s not what you’re looking for, and your 401(k) plan makes an advisor available to you, you may be able to get more specific advice. Or, if you want more help, you could hire a financial professional to work with you on your overall plan as it relates to your long- and short-term goals.

Multiple Retirement Accounts

Another possibility might be to go with the basic choices in your workplace 401(k), but also open a separate investing account with which you could take a more hands-on approach. You could try a traditional IRA if you’re still looking for tax advantages, a Roth IRA (read more about what Roth IRAs are) if you want to limit your tax burden in retirement, or an account that lets you invest in what you love, one stock at a time.

There are some important things to know, though, before deciding between a 401(k) vs. an IRA.
💡 Quick Tip: Can you save for retirement with an automated investment portfolio? Yes. In fact, automated portfolios, or robo advisors, can be used within taxable accounts as well as tax-advantaged retirement accounts.

How Asset Allocation Can Make a Difference

How an investor allocates their resources can make a difference in terms of their ultimate returns. Generally speaking, riskier investments tend to have higher potential returns — and higher potential losses. Stocks also tend to be riskier investments than bonds, so if an investor were to construct a portfolio that’s stock-heavy relative to bonds, they’d probably have a better chance of seeing bigger returns.

But also, a bigger chance of seeing a negative return.

With that in mind, it’s going to come down to an investor’s individual appetite for risk, and how much time they have to reach their financial goals. While there are seemingly infinite ways to allocate your investments, the chart below offers a very simple look at how asset allocation associates with risks and returns.

Ways to Make the Most of Investment Options

It’s up to you to manage your employer-sponsored 401(k) in a way that makes good use of the options available. Here are some pointers.

Understand the Match

One way to start is by familiarizing yourself with the rules on how to maximize the company match. Is it a dollar-for-dollar match up to a certain percentage of your salary, a 50% match, or some other calculation? It also helps to know the policy regarding vesting and what happens to those matching contributions if you leave your job before you’re fully vested.

Consider Your Investments

With or without help, taking a little time to assess the investments in your plan could boost your bottom line. It may also allow you to tailor your portfolio to better accomplish your financial goals. Checking past returns can provide some information when choosing investments and strategies, but looking to the future also can be useful.

Plan for Your Whole Life

If you have a career plan (will you stay with this employer for years or be out the door in two?) and/or a personal plan (do you want to buy a house, have kids, start your own business?), factor those into your investment plans. Doing so may help you decide how much to invest and where to invest it.

Find Your Lost 401(k)s

Have you lost track of the 401(k) plans or accounts you left behind at past employers? It may make sense to roll them into your current employer’s plan, or to roll them into an IRA separate from your workplace account. You might also want to review and update your portfolio mix, and you might be able to eliminate some fees.

Know the Maximum Contributions for Retirement Accounts

Keep in mind that there are different contribution limits for 401(k)s and IRAs. For those under age 50, the 2023 contribution limit is $22,500 for 401(k)s and $6,500 for IRAs. For those 50 or older, the 2023 contribution limit is $30,000 for 401(k)s and $7,500 for IRAs. Other rules and restrictions may also apply.

Learn How to Calculate Your 401(k) Rate of Return

This information can be useful as you assess your retirement saving strategy, and the math isn’t too difficult.

For this calculation, you’ll need to figure out your total contributions and your total gains for a specific period of time (let’s say a calendar year).

You can find your contributions on your 401(k) statements or your pay stubs. Add up the total for the year.

Your gains may be listed on your 401(k) statements as well. If not, you can take the ending balance of your account for the year and subtract the total of your contributions and the account balance at the beginning of the year. That will give you your total gains.

Once you have those factors, divide your gains by your ending balance and multiply by 100 to get your rate of return.

Here’s an example. Let’s say you have a beginning balance of $10,000. Your total contributions for the year are $6,000. Your ending balance is $17,600. So your gains equal $1,600. To get your rate of return, the calculation is:

(Gains / ending balance) X 100 =

($1,600 / $17,600) X 100 = 9%

Savings Potential From a 401(k) Potential by Age

It can be difficult to really get a feel for how your 401(k) savings or investments can grow over time, but using some of the math above, and assuming that you keep making contributions over the years, you’ll very likely end up with a sizable nest egg when you reach retirement age.

This all depends, of course, on when you start, and how the markets trend in the subsequent years. But for an example, we can make some assumptions to see how this might play out. For simplicity’s sake, assume that you start contributing to a 401(k) at age 20, with plans to start taking distributions at age 70. You also contribute $10,000 per year (with no employer match, and no inflation), at an average return of 5% per year.

Here’s how that might look over time:

Using time and investment returns to supercharge your savings, you could end up with more than $2 million through dutiful saving and investing in your 401(k). Again, there are no guarantees, and the chart above makes a lot of oversimplified assumptions, but this should give you an idea of how things can add up.

Alternatives to 401(k) Plans

While 401(k) plans can be powerful financial tools, not everyone has access to them. Or, they may be looking for alternatives for whatever reason. Here are some options.

Roth IRA

Roth IRAs are IRAs that allow for the contribution of after-tax dollars. Accordingly, the money contained within can then be withdrawn tax-free during retirement. They differ from traditional IRAs in a few key ways, the biggest and most notable of which being that traditional IRAs are tax-deferred accounts (contributions are made pre-tax).

Learn more about what IRAs are, and what they are not.

Traditional IRA

As discussed, a traditional IRA is a tax-deferred retirement account. Contributions are made using pre-tax funds, so investors pay taxes on distributions once they retire.

HSA

HSAs, or health savings accounts, are another vehicle that can be used to save or invest money. HSAs have triple tax benefits, in that account holders can contribute pre-tax dollars to them, allow that money to grow tax-free, and then use the holdings on qualified medical expenses — also tax-free.

Retirement Investment

Typical returns on 401(k)s may vary, but looking for an average of between 5% and 8% would likely be a good target range. Of course, that doesn’t mean that there won’t be up or down years, and averages, themselves, can be a bit misleading.

While your annual return on your 401(k) may vary, the good news is that, as an investor, you have options about how you save for the future. The choices you make can be as aggressive or as conservative as you want, as you choose the investment mix that best suits your timeline and financial goals.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

What is the typical 401(k) return over 20 years?

The typical return for 401(k)s over 20 years is between 5% and 8%, assuming a portfolio sticks to an asset mix of roughly 60% stocks and 40% bonds. There’s also no guarantee that returns will fall within that range.

What is the typical 401(k) return over 10 years?

Again, the average rate of return for 401(k)s tends to land between 5% and 8%, with some years providing higher returns, and some years providing lower, or even negative returns.

What was the typical 401(k) return for 2022?

The average 401(k) lost roughly 20% of its value during 2022, as increasing interest rates and shifting economic conditions over the course of the year (largely due to increasing inflation) caused the economy to sputter.

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