It's well established that saving and investing via your 401(k) is likely to benefit your financial standing in the long run. However, it's probably not the best idea to rely entirely on your 401(k) for retirement savings. Many factors, such as your employment status, tax bracket, and lifestyle choices, all play into the degree to which you rely on your employer-sponsored retirement plan. At the very least, gaining an understanding of other retirement savings options is a good idea. Here, we'll look at five reasons not to rely solely on your 401(k) to fund expenses in retirement.
1. Your tax rate in retirement is unknown
When you save in a 401(k), you implicitly agree to defer income taxation to a future date -- most commonly, when you retire and withdraw the money. Saving and investing in a 401(k) is often recommended, because it's assumed that your tax rate in retirement (when you're no longer working) will be lower than it is currently (when you're earning money). This is possible but does not account for potential changes in tax law that are almost certainly going to be disadvantageous to the individual. In other words, taxes are likely to go up.
The antidote to this is to consider tax-free retirement vehicles in addition to your 401(k), such as a Roth IRA. By choosing a Roth IRA, you'll add money that's already been taxed at today's rates, allowing you to withdraw that money tax-free in retirement. Roth IRA investments also allow for tax-free compounding, which is sure to work to your benefit over many decades. Adding a Roth IRA to work with your 401(k) is a form of tax diversification: By maintaining different accounts with different tax treatment, you protect yourself against unknown tax changes.
2. 401(k)s come with early withdrawal penalties
Once your money is locked in your 401(k), you won't be able to withdraw it without a 10% penalty until you're at least 59 1/2 years old. Unless your withdrawal is exempt from penalty -- which is the case in only a minority of withdrawals -- you will be penalized for touching this money early. If you aren't ready to put your funds away for the long haul, you may want to consider saving for a down payment or keeping funds accessible in a taxable brokerage account. You may be taxed more today to do this, but you'll also retain immediate access to your money, which has considerable value.
3. 401(k)s can be expensive
This will vary from employer to employer, but it's entirely possible that your company's 401(k) investment menu includes a laundry list of very expensive mutual funds. As mentioned in previous articles, you don't need to pay more than a very nominal fee to invest in mutual funds or exchange-traded funds (ETFs), and you certainly shouldn't be forced to invest in expensive ones, either (generally, more than 0.50% per fund would be considered expensive). If your company is offering a 401(k) with expensive investment options, you might consider investing only up to the company match and looking into alternative ways to invest the remainder of your money.
4. You don't choose your company's 401(k) provider
This is more of a cosmetic concern, but remember that you won't be the one choosing your company's 401(k) plan provider. Your 401(k) provider might have a clunky website or poor customer service, or it may not be able to provide the financial planning tools you want. You're essentially at the mercy of your employer here. If there is no employer match and your company's 401(k) is otherwise undesirable, you might consider other retirement vehicles like a non-deductible IRA or a Roth IRA. Additionally, a taxable brokerage account is always an option.
5. Your 401(k) will contain future tax payments
A significant portion of your 401(k) balance will be used to pay taxes in the future. In a sense, it's not a pure reflection of "spendable" retirement money. If you have, for example, $600,000 in your 401(k) at retirement, you should mentally budget for about $200,000 to go straight to the IRS upon withdrawal. The actual amount due to the IRS may be less than that, but it's important to know that your 401(k) contains taxable income waiting to be declared. Conversely, a Roth IRA is yours, and entirely yours, for as long as it exists.
Don't overcommit before reviewing
A 401(k), in most circumstances, is a great way to save for retirement. Before committing the full amount every year to your 401(k), however, it's best to build a broad-based financial plan that considers your personal goals as well as your employment and tax status -- in addition to clearly delineating the knowns and unknowns of your individual circumstances. Your company's retirement plan is a great place to start saving for retirement, but take the time to know the details and look elsewhere if necessary.