Some 60 million people are actively saving money to a 401(k). The workplace retirement account has advantages, such as employer-funded contributions and tax-deferred investment earnings. Still, 401(k)s are not perfect. Depending on your situation, a 401(k) on its own might not fully support your retirement savings goals.
To help you decide if you should save and invest outside of your 401(k), here is a closer look at three drawbacks of using only a 401(k) for retirement.
Your 401(k) is not free. You pay investment fees and, probably, administration fees. Your plan may also charge you for extra services, things like processing 401(k) loans or hardship withdrawals.
401(k) investment fees. The mutual funds in your 401(k) have their own operating costs, which are passed along to you and other shareholders. You'll see these costs disclosed in the fund's documentation as fund expense ratios.
Fund expense ratios look small on paper, usually ranging from 0.03% to 0.75% of your invested balance. Still, this is a cost you absorb every year, and it reduces your overall investment returns. After 30 years of saving and investing in your 401(k), even a tiny expense ratio can add up to tens of thousands of dollars.
The best 401(k)s give you access to funds with low expense ratios. It's not ideal if your retirement plan only offers funds with expense ratios of, say, 0.5% or higher.
Administration fees. On top of fund expenses, you may also pay an annual administration fee to your plan. This fee typically ranges from 0.50% to 2% -- with larger companies charging less and smaller companies charging more.
If your plan charges you 2% annually and your funds charge 0.50%, fees are siphoning away 2.5% of your investment returns each year. Again, that's not ideal.
Service fees. Service fees should mostly be one-off events. Fortunately, that limits their impact versus recurring administration or investment fees.
2. Limited investment choices
Your 401(k) offers you a small menu of investment choices -- maybe 15 or 20 mutual funds. You might find that investment menu insufficient in two scenarios:
- You are an experienced investor who wants specific specialty exposures.
- All of your fund choices have high expense ratios.
A second investing account such as an IRA or taxable brokerage account can help you manage either scenario -- assuming that account has access to the full range of exchange-traded securities. You'd use that access to diversify and to reduce what you pay, on average, in fund expenses.
3. Withdrawal restrictions
The IRS discourages early withdrawals from your 401(k) by assessing a 10% penalty on top of the usual taxes. An "early" withdrawal is before you are 59 1/2 years old or, in some situations, before you are 55. Those withdrawal rules may not work if you want the flexibility to retire in your early 50s.
Fortunately, you shouldn't need access to your entire retirement savings balance to leave the workforce early. You'd only need enough liquidity to pay your bills until you reach the 59 1/2 milestone.
You could get around the 401(k) withdrawal restrictions by holding a portion 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'd pay taxes each year on realized gains, dividends, and interest. You can keep your tax liability to a minimum by holding equities that don't pay dividends for long periods of time -- since your gains on stocks only become taxable when you sell.
Take your matching contributions
While a 401(k) isn't the perfect retirement savings solution on its own, an account does have a feature you don't want to pass up -- employer matching contributions. If your employer has a matching program, take advantage of it. Those free deposits will cover your 401(k) fees and expedite the growth of your savings.
If you want to save outside of your 401(k), do so after you max out your employer match.
401(k) plus a taxable brokerage account
A 401(k) paired with a taxable brokerage account can address a huge range of situations and retirement savings goals. You'd capitalize on employer match and tax-free contributions with the 401(k), along with low fees, investment diversity, and unrestricted withdrawals from your brokerage account. With that feature set, you could be on your way to making your retirement dreams a reality.