Advantages & Disadvantages of 401ks and Regular Savings Accounts

Regular savings accounts and 401(k)s can both help you meet your financial goals and have intended uses for cash savings vs. retirement savings.

Regular savings accounts and 401(k)s can both help you meet your financial goals and have intended uses for cash savings vs. retirement savings. While you may put cash in your savings account to plan for big purchases such as a new home or your child's education, a 401(k) allows you to regularly save for your retirement while maximizing your return and possibly getting matched funds from your employer. When comparing regular savings vs. 401(k) accounts, you'll find these options have different advantages and disadvantages when it comes to liquidity, potential return, security, tax implications, account requirements and fees.

Exploring 401(k) Advantages

Investing your money in a 401(k) gives you advantages that make this type of account a good choice for long-term retirement savings and a suitable alternative to an IRA.

Higher potential earnings: While your return will ultimately depend on market performance and your allocation of investments in the 401(k), Investopedia notes you can expect to make 5 to 8 percent return on average each year if you use a moderate risk approach (60 percent equity and 40 percent debt). On top of this, your employer may also contribute a portion of your salary, meaning even more money on which you can see a return.

Tax advantages: If you've got a traditional 401(k), the contributions you make are on a pre-tax basis; this means you won't pay federal income tax on that amount during the contribution year and will instead defer those taxes until you make withdrawals. If you've got a Roth 401(k), you'll pay taxes on your contributions the tax year you make them; this can be an advantage if you're in a low tax bracket now and expect to be in a higher one when you begin taking distributions.

Generous contribution limits: You can usually contribute to your 401(k) account for as long as you're employed; this applies even if you're over 70 1/2 as long as you're at the same company offering the plan. The annual contribution amounts are usually generous: For the 2019 tax year, the limit is $19,000, plus you can invest an extra $6,000 as a catch-up contribution if you're at least 50.

Availability of 401(k) loans and emergency withdrawals: Although you can't take out money as easily as you would with a savings account, your plan may allow you to take out loans. You can also withdraw money early for certain emergencies, although this may come with a 10 percent penalty.

Provides some creditor protection: Since these accounts aren't liquid assets, another one of the 401(k) advantages is that creditors usually can't seize the funds to pay for unpaid debts, unless you've named the account as collateral or the creditor is the Internal Revenue Service or another government entity. Even if the IRS does try to take the funds, this will often only be your amount of allowed distributions.

Considering 401(k) Disadvantages

A 401(k) also comes with some limitations and risks that you should consider before choosing how to invest your money.

Requirements to open account: Unless you're self-employed, you'll need to work for a company offering a 401(k) to be able to invest in this account. Even then, you may need to have a certain length of employment to qualify.

Less liquidity: Ease of access to funds is a big difference between a 401(k) and savings account. Your plan will have certain conditions under which you can withdraw money early, such as for emergencies. But unless you're 59 1/2 or have a specific hardship, you'll be hit with a 10 percent early withdrawal penalty. This penalty is on top of having to pay any owed taxes on the money and losing out on a potential return had the money stayed in your account. A 401(k) loan can be an alternative but can come with penalties if you don't pay it back within a set amount of time.

Potential to lose value: Despite the higher return potential in the long run than savings accounts, your 401(k) can lose money in times of financial instability. Losses are usually short-term, so you can simply wait until your account recovers and reconsider your investment strategy. However, losses can be a bigger problem if you're already retired and need to live off these funds.

Administrative fees: 401(k) plans come with investment, plan administration and service fees that can add up, especially over time. These fees may be flat, based on your account balance or a combination, so check your plan documents.

Less control over your investments: Unlike with developing your own portfolio, your employer will offer a limited selection of options for you to choose for your 401(k), and you'll have to select your investments (such as stocks, money market funds and target-date funds) from that list. If you're willing to take on risks and wish to invest in specific lucrative stocks, a 401(k) can be a limitation. You'll need to do careful research – and possibly consult with a financial advisor – to choose the right mix for your financial goals.

Exploring Regular Savings Account Advantages

Savings accounts come with some advantages that can make them particularly appealing for short-term cash savings vs. retirement savings as well as for daily use.

Better liquidity: You can simply visit a bank branch or ATM to withdraw money from your savings account any time you need it. This ease of access offers protection in the event of an emergency when you need some quick cash and want to avoid credit card interest. You can also easily use your funds for money transfers and online bill payments.

Ease of opening account: You can simply apply online or visit a local bank to set up a regular savings account. While some banks do require a small minimum initial deposit to open the account, others don't even require this and let you deposit money later.

Accumulation of interest: Compared to storing money in a non-interest-bearing checking account or at home, you can expect to gain at least a small return on your savings. While this can be as little as 0.01 percent, banks may offer tiers of higher rates depending on your account balance. Online banks like Ally Bank and Betterment also offer higher rates – a bit over 2 percent as of July 2019.

Insurance against loss: You can rest assured that the Federal Deposit Insurance Corporation offers you protection for up to $250,000 in your savings account if your bank fails for some reason. This offers more peace of mind than worrying you'll forget where you hid your cash savings in your house or seeing your savings plummet in an economic downturn.

Considering Regular Savings Account Disadvantages

Although savings accounts make it easy to access your money as you need it and offer more stability, understand these downsides when considering your savings options.

Account fees: Banks may charge you a monthly fee to simply have a savings account unless you meet minimum balance requirements or have other established accounts. You may also pay an annual fee on top of that.

Withdrawal limits: Each billing cycle, you can make six withdrawals for your savings account without paying a fee, although some banks offer exceptions for high balances. Otherwise, you'll pay a transaction charge, typically $10, for each additional withdrawal.

Typically lower earnings: Although you may feel tempted to put more of your money in a savings account during an economic downturn, even the highest savings account interest rates don't exceed the long-term return you can expect from a 401(k).

More temptation to spend: Having easy access to your savings means you may feel tempted to take out money for unnecessary purchases, and this can hinder your long-term goals to buy a house or car.

Taxes on interest accrued: Savings accounts don't offer tax benefits like retirement accounts do; instead, you'll just end up paying income tax on the interest earned throughout the year.