3 disadvantages of only using a 401 (k) for retirement
Some 60 million people are actively saving money on a 401 (k). The workplace retirement account has benefits, such as employer-funded contributions and tax-deferred investment income. However, 401 (k) are not perfect. Depending on your situation, a 401 (k) on its own may not fully support your retirement savings goals.
To help you decide if you should save and invest outside of your 401 (k), here’s a closer look at three downsides to just using a 401 (k) for retirement.
Your 401 (k) is not free. You pay an investment fee and, possibly, an administration fee. Your plan may also charge you for additional services, such as processing 401 (k) loans or hardship withdrawals.
401 (k) investment costs. Your 401 (k) mutual funds have their own operating costs, which are passed on to you and other shareholders. You will see these costs disclosed in the fund documentation as fund expense ratios.
Fund expense ratios look low on paper, typically ranging from 0.03% to 0.75% of your invested balance. However, this is a cost that you absorb each year and which reduces the overall return on your investments. After 30 years of saving and investing in your 401 (k), even a small expense ratio can reach tens of thousands of dollars.
The best 401 (k) give you access to funds with low expense ratios. This is not ideal if your pension plan only offers funds with expense ratios of, say, 0.5% or more.
Administration fees. In addition to the fund costs, you may also pay an annual administration fee to your plan. These fees typically range from 0.50% to 2%, with larger businesses charging less and smaller businesses charging more.
If your plan charges you 2% per year and your funds charge 0.50%, the fees siphon 2.5% of your investment returns each year. Again, this is not ideal.
Service charge. Service charges should primarily be one-time events. Fortunately, this limits their impact compared to recurring administration or investment costs.
2. Limited investment choices
Your 401 (k) gives you a small menu of investment choices – maybe 15 or 20 mutual funds. You might find this insufficient investment menu in two scenarios:
- You are an experienced investor who wants specific specialist exhibitions.
- All of your fund choices have high expense ratios.
A second investment account such as an IRA or taxable brokerage account can help you handle either scenario, assuming that account has access to the full range of exchange-traded securities. You would use this access to diversify and reduce what you pay, on average, in fund spending.
3. Withdrawal restrictions
The IRS discourages early withdrawals from your 401 (k) by imposing a 10% penalty on top of the usual taxes. An “early” withdrawal takes place before the age of 59 and a half or, in some situations, before the age of 55. These withdrawal rules may not work if you want the option to retire in your early 50s.
Fortunately, you shouldn’t need to access all of your retirement savings to leave the workforce sooner. You would only need enough cash to pay your bills until you hit the 59 1/2 milestone.
You can get around the 401 (k) withdrawal restrictions by holding some of your savings in a more flexible account. A taxable brokerage account would be ideal since it has no withdrawal restrictions. The trade-off is that you would pay taxes every year on earned earnings, dividends, and interest. You can keep your tax liability to a minimum by holding stocks that don’t pay dividends for long periods of time, because your gains on stocks only become taxable when you sell.
Take your matching contributions
While a 401 (k) account isn’t the perfect retirement savings solution on its own, an account has one feature you don’t want to miss out on – employer matching contributions. If your employer has a buddy program, take advantage of it. These free deposits will cover your 401 (k) fees and accelerate your savings growth.
If you want to save outside of your 401 (k), do so after you maximize your correspondence with the employer.
401 (k) plus a taxable brokerage account
A 401 (k) paired with a taxable brokerage account can meet a wide range of retirement savings situations and goals. You would take advantage of employer matching and tax-exempt contributions with the 401 (k), along with low fees, variety of investments, and unlimited withdrawals from your brokerage account. With this feature set, you could be on your way to making your retirement dreams come true.