Using a 401(k) vs. Stock Picking

Contributing to a 401(k) retirement account and investing in individual stocks outside a retirement account represent two drastically different approaches. A 401(k) account is part of many employer-sponsored retirement plans. They offer immediate tax savings and, sometimes, employer matching of contributions. They also have notable restrictions. Investing in individual stocks offers no comparable tax benefits or employer matches. However, the benefits of greater liquidity and choice mean stock picking has a place in some investment portfolio strategies.

You have a myriad of choices for investing. Consider working with a financial advisor as you seek to match those choices with your goals and risk profile.

Before we dive into 401(k) plans vs. stock picking, remember that while both can be important parts of planning for retirement, other income sources can be equally or even more important. Social Security benefits, corporate pensions, family homes and inheritances, for instance, should be factored into retirement planning as well.

Basics of Stock Picking and 401(k)s

Stock pickers are the original securities investors. They mainly try to buy shares that are going to rise in value, although they may also invest for dividend income. There are many different systems of picking stocks, such as the CAN-SLIM system.

There are also different sorts of stock pickers. Passive investors seek long-term appreciation, while active traders try to surf the tides of rising and falling prices. Stock pickers have to buy shares with after-tax dollars and pay taxes on any gains. However, they can buy and sell any time they want, and use the proceeds for any purpose.

The 401(k) came into existence after tax laws changed in 1978. The accounts are part of many employer-sponsored retirement plans. Employees can have contributions automatically deducted from paychecks and don’t have to pay taxes on contributions until they are withdrawn. Employers may also make extra contributions to their employees’ accounts. However, 401(k) owners generally can’t withdraw money until age 59.5 without facing penalties and also have limited choices for investments.

401(k) Advantages

The fact that 401(k) contributions are free of immediate taxation is among the most significant benefits of these accounts. Contributors don’t have to pay taxes on any funds they put into their accounts until they begin taking money out at or near retirement age.

Employer matching is another benefit. Many employers match employee contributions dollar-for-dollar up to a certain amount, significantly increasing the amount of money being socked away for retirement.

But above all, 401(k)s are simple and convenient ways to save for retirement. With money automatically deducted from your payment and invested in mutual funds, it’s no wonder 401(k)s have become a go-to offering for employers.

401(k) Disadvantages

The advantage of saving on taxes now may be offset if tax rates are higher when the 401(k) holder retires. Younger investors with limited earnings may wind up paying more in taxes on future 401(k) withdrawals even if tax rates are unchanged if their incomes rise enough. While employer matches are seen as free money, employers who don’t match may pay higher salaries, which employees might prefer. In addition, some plans call for a vesting period of several years before matches are fully owned by the employee.

Lack of liquidity is a serious limitation of 401(k) plans. Account owners generally can’t withdraw funds until age 59.5 without paying a 10% penalty plus income tax. This means 401(k) funds are not available for non-retirement financial goals such as saving for a house.

Most 401(k) plans also offer limited investment alternatives. A handful of mutual funds is a typical offering. Employees who want more control of their investments may feel frustrated by 401(k) choices.

Administrators who run 401(k) plans charge fees on top of the fees charged by mutual funds. Sometimes the combination means the fees negate the plans’ tax advantages.

There are also limits to how much you can invest in a 401(k) each year. For tax year 2024, 401(k) participants can contribute $23,000, while those 50 and over can add an extra $7,500 to their account. In 2023 those limits were $22,500 and $7,500, respectively.

Required minimum distributions (RMDs) are IRS-mandated withdrawals from 401(k) plans that must begin when the owner reaches age 73. Those who turned 72 in 2022, however, had to follow the rules before the SECURE 2.0 Act increased the RMD age and continue to take their RMDs without delay. RMDs can create unwanted tax liabilities for retirees, but failing to take them could mean paying a 50% penalty on the amount that was required but not withdrawn.

Finally, 401(k) plans are available only to employees of companies that offer them. Many businesses, especially smaller employers, do not.

Stock Picking Advantages

Liquidity is the major advantage of stock picking. Individual stock investors can buy and sell as desired at any time and for any purpose without penalties for early withdrawal. This can make stock picking a more effective way to achieve pre-retirement goals such as saving for college or buying a home.

Stock pickers have nearly unlimited choices. They can buy any of the thousands of stocks, bonds, mutual funds, exchange-traded funds and other securities listed on markets. Investors who are confident in their ability to select winning investments have a much larger field from which to select.

Any adult with money can buy stocks. Investors with or without jobs can open accounts at banks, online and with traditional brokers.

Stock Picking Disadvantages

Lack of any tax advantage can be a serious drawback to stock picking compared to 401(k) accounts. Stock pickers have to invest after-tax money and pay taxes on any gains from their investments.

Stock pickers in general perform poorly compared to the passively managed index funds that are standard offerings in 401(k) plans. While investors may feel better knowing they are in control of their stock selections, the end result for many will be lower returns compared to a 401(k).

Bottom Line

Both 401(k)s and stock picking have roles to play in many investors’ financial plans. 401(k) plans are generally better for accumulating retirement funds, thanks to their tax advantages. Stock pickers, on the other hand, enjoy much greater access to their funds, so they are likely to be preferable for meeting interim financial goals including home-buying and paying for college.

Financial Planning Tips

Selecting how much invest in a 401(k) or individual stocks outside a retirement plan is a complex decision that requires evaluating taxes, future financial needs and individual risk tolerance. That’s where a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Life insurance is another important product to consider as part of your financial plan, especially if you have children who are minors. To see how much life insurance you should buy, use SmartAsset’s life insurance calculator.