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.
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.