A 401(k) retirement plan is an excellent tool to help
employees save for retirement. Many employers offer a company match, which is
basically extra compensation. Not only that, but you also usually get a tax
break for your contributions in the year you make them.
But if you're only saving for retirement in a 401(k), it
could end up hurting you when you're ready to start living on your savings.
Here are five drawbacks of only using a 401(k) for retirement.
1. Fees
The biggest drawback of a 401(k) plan is they usually come
with at least some fees. There are plan administration fees, investment fees,
and service fees, among others.
If you work for a small company, the fees are worse. Since
there are fewer participants and fewer assets to spread the fees across,
participants in small-business retirement plans can get hit with fees as high
as 2%. Most large 401(k) plans -- those with greater than $100 million in
assets -- can get their fees down below 1% with the largest below 0.5%.
Even with fees of just 0.5% of assets under management,
you'll end up paying quite a bit if you throw all your extra money into your
401(k). If you're maxing out your 401(k) with $19,500 per year in contributions,
and your employer adds another $3,000 each year, you'll end up paying $261,000
in fees, losing 9.5% of your returns in the process.
If your 401(k) has high fees, consider investing enough to
get your company match, and then exploring other savings options such as an IRA
or taxable brokerage account.
2. Limited investment options
401(k) plans typically limit your investment options to a
selection of ETFs and mutual funds. What's more, these funds may have higher
expense ratios than you could get for similar, or in some cases, the same fund
outside your retirement plan.
If you learn about a stock, fund, or other investment you
want to buy for your retirement savings, but it's not offered by your plan,
tough luck.
The reason 401(k) investment choices are limited is to keep
administration expenses low and to ensure investments in the plan meet ERISA
requirements.
Some 401(k) plans offer a self-directed brokerage option,
but those aren't very common. You may have to pay an additional fee for the
privilege as well. If you save in an IRA or a standard brokerage account, your
investment choices are much broader.
3. You can't always withdraw your money when you want
Your 401(k) account is for retirement. Therefore, the IRS
discourages you from withdrawing funds before what it deems "retirement
age." Right now, that's age 59 1/2. There's an exception to the rule,
which allows you to start taking withdrawals when you separate from service
from the employer sponsoring the plan in the year you turn 55 or later. Note,
that applies only to a 401(k) at your last employer.
You can also tap into your 401(k) account early by taking
substantially equal periodic payments under code 72(t). Doing so, you're
committed to taking those withdrawals for at least five years or until you turn
59 1/2, whichever is later.
If you decide to call it quits before 55, it's a lot harder
to live off your investments if they're all held in a 401(k) account. A Roth
account will let you withdraw your contributions but not your earnings. There
are certainly some workarounds to access your money early, but none of them are
exactly convenient.
4. You may be forced to withdraw your money when you
don't want
401(k) accounts also have required minimum distributions
starting at age 72. That's for both traditional 401(k) savings and Roth 401(k)
accounts. By that age, you'll be collecting Social Security benefits, and the
tax implications of taking a taxable distribution larger than you need could be
substantial. Not only will you have to pay taxes on the distribution, but it
could force some of your Social Security benefits to become taxable as well.
Converting as much as you can, without paying too much in
taxes, from a traditional 401(k) to a Roth IRA can help mitigate the issue.
Another option for charitable retirees is using a qualified charitable distribution,
which counts toward required minimum distributions but won't affect your
taxable income.
5. Less control over your taxes
Taxes can become one of your biggest expenses in retirement
if you don't plan properly. And if you only save for retirement in a 401(k)
account, you won't be able to do much to avoid paying them. All employer
contributions to a 401(k) are tax deferred, which means you'll pay taxes upon
withdrawal. And not everyone has access to a Roth 401(k) where you pay taxes
upfront instead of upon withdrawal.
When you make a withdrawal from a traditional 401(k), you
pay ordinary income tax. The rate on ordinary income is currently higher than
the tax rate on long-term capital gains. Being able to mix your retirement
account distributions with capital gains allows you to minimize your taxes, but
you won't have that option if you only have savings in a 401(k).
If you want to maximize your retirement savings and gain
more flexibility in your financial planning, you'll probably need to save outside
your 401(k) plan at work.
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