A 401(k) is a great retirement savings account for most people. It's very easy to use since your employer manages it. It comes with big tax breaks. And your employer might even give you free money to put into it if the company you work for matches 401(k) contributions.
If you get an employer match, you should always aim to contribute enough to max it out before using any retirement accounts. After all, passing up on free money usually isn't the best financial move.
But once you've earned that employer match, there are some very good reasons to venture out into other retirement plans. And there are three big drawbacks to using a 401(k) alone.
Here's what they are.
1. You could get stuck with hidden fees
Fees are never fun for investors because they eat away at returns. But for retirement investors who are leaving their money in a 401(k) account for decades, the cost of fees can be astronomical as they suck money from your account year after year.
The good news is, most 401(k) account fees are pretty low. Recent research from Employee Fiduciary found the average all-in fee was 1.18% in their 2021 study. However, the bad news is, Employee Fiduciary also found that close to 76% of 401(k) plans incurred "hidden" administration fees.
To find out the truth of what you're paying, you should always check 408(b)(2) fee disclosures that your plan provides. You might find out the costs are higher than you're comfortable with -- a very big drawback of sticking with a 401(k) as your sole retirement plan.
That's especially true as a growing number of brokers have been working to eliminate commissions and other costs, which may mean investing in an IRA with a discount broker is much less expensive.
2. You may end up with a higher tax bill
If you only have access to a traditional 401(k) and not a Roth IRA, sticking with that 401(k) as your sole account would mean making all your retirement account contributions with pre-tax dollars. That sounds like a good thing -- until you consider that all your distributions from that account will be taxable income as a retiree.
If you think you'll be in a lower tax bracket in retirement than when you're working, an up-front tax break may seem like a better deal. But keep in mind that tax rates are currently near historic lows, and the government has been spending a lot of money for a very long time without major tax increases.
It seems inevitable rates will have to go up eventually to deal with the rising deficit and debt. That may very well happen before your retirement, so your rate could end up higher than anticipated.
You should also consider that Social Security benefits become taxable once your "provisional" income exceeds a certain threshold (and the threshold isn't indexed to inflation, so it gets lower in real terms every year). Any distributions from a traditional 401(k) count in this income calculation, but distributions from Roth accounts won't.
Once you look at the big picture, you may decide putting some retirement money into a Roth IRA is a better bet than sticking solely with your 401(k) alone.
3. You may be limiting your return on investment
Most people with a 401(k) get to pick their investments from a very small pool of assets. These most likely consist of index funds.
Since index funds involve buying a small stake in lots of different assets, it's unlikely they are going to beat the market by much. While these investments are less risky than others, such as individual stocks or cryptocurrencies, you also limit potential returns because so many companies within the index would have to outperform in order to beat the market by much.
If you want to be able to pick retirement investments from a wider pool of potential assets, you aren't going to be able to put all your retirement funds into a 401(k). Of course, before you take on added risks, you need to be confident you've got a sound investment thesis and won't be putting your future security at risk.