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Three Pitfalls of Only Using a 401(k) for Retirement

By Ryan Downie – Oct 9, 2020 at 9:18AM

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A 401(k) offers great features as a retirement account, but relying exclusively on this investment vehicle does have its limits.

Investors love 401(k) accounts for retirement savings, but they provide the best results when used in conjunction with other investment vehicles. Tax benefits, systematic saving, asset growth, and employer contributions are all fantastic features of 401(k)s, but relying on them exclusively can have negative tax ramifications, limit investment opportunities, and hamper liquidity. Investors should consider other types of accounts to develop a comprehensive retirement plan that is designed to flourish in different circumstances.

1. 401(k) accounts have very specific tax exposure

Tax advantages are among the most frequently cited benefits for 401(k)s. Contributions are pre-tax, meaning that they are deducted from paychecks and excluded from taxable income, which allows these funds to grow on a tax-deferred basis throughout a person's career. Qualifying withdrawals are taxed as ordinary income while avoiding capital gains taxation.

Many people expect to be in a lower tax bracket during retirement relative to their working years. The same lifestyle can typically be sustained in retirement on a lower income as payroll taxes are not incurred, and expenses from commuting, child-rearing, and housing are often no longer in the picture. This wisdom has merit, but tax diversification can be transformative to a portfolio.

Retirement plan folder on a desk with pens, a calculator, and glasses.

Image source: Getty Images.

Retirees who only hold assets in a 401(k) are fully exposed to the income tax rates that will be in place during their retirement years. Many people believe that tax rates will necessarily rise in the future to support consistent federal budget deficits. Current marginal tax rates fall in the middle of a wide historical range, so it is feasible that rates will change.

Investors can mitigate this risk by also saving into Roth IRAs or regular brokerage accounts. Roth accounts require payment of taxes at the time of earning, but withdrawals are tax-free. Brokerage account taxation depends on the security held. The sale of assets that appreciate will be subject to capital gains tax, whereas interest and dividends are taxed as ordinary income, and certain municipal bonds will generate interest that is not subject to federal income tax.

2. Retirement accounts are functionally illiquid

Any asset can be earmarked for retirement in a financial plan, but 401(k)s can only be used in retirement. Early withdrawal is subject to income taxes and a 10% penalty, eliminating any tax advantage and erasing savings. There are important exceptions such as first-time home buyer and hardship exemptions, but these withdrawals should be made opportunistically or out of necessity. The time horizon for home payments is shorter than retirement, so retirees won't be optimizing their 401(k)s if they withdraw funds early.

Brokerage accounts don't provide tax advantages, but they are liquid and available for unexpected emergencies or opportunities. Roth IRAs will not allow holders to withdraw appreciated capital, but they also provide more flexibility to access contributed capital. If investors need funds to start a business or purchase an investment property, they won't be able to tap their 401(k) savings without penalty.

Retirement accounts also aren't available to cover unexpected expenses that might exceed emergency fund savings. Data from Creditcards.com shows that many people mismanage this portion of their financial plan -- 39% of American households had credit card balances in 2017. Meanwhile, 32% of Americans were invested in 401(k) accounts that same year, so it seems that many people actively contribute to 401(k)s while carrying high-interest debt. Retirement accounts are unlikely to provide returns that exceed the high interest rates associated with credit cards, so it's poor planning to allocate cash to a 401(k) instead of paying down that debt.

3. Stuck with the terms of the employer's plan

The terms of 401(k)s are dictated by your employer's benefits package and their agreement with the relevant financial institution. Employees have little input on the features or fees of their 401(k). Account management fees are generally reasonable and subject to regulation, but there are still examples with relatively high fees, especially for employees of small businesses. Account holders also must rely on the plan representative, customer service, or online portal for information, which are often insufficient. Moreover, some employers offer no contribution match, eliminating one of the most attractive features of a 401(k). 

Most 401(k)s provide a limited range of investment choices. For investors seeking more flexibility, consider IRAs from reputable brokerages, which usually offer a wider range of securities.

Ultimately, 401(k) accounts provide fantastic benefits and should be utilized by most retirement investors. That said, it is still a good idea to embrace alternatives such as Roth IRAs, traditional IRAs, and brokerage accounts at the same time to provide diversification, flexibility, and control.

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