Please ensure Javascript is enabled for purposes of website accessibility

3 Drawbacks of Using Only a 401(k) for Retirement

By Catherine Brock – Updated Sep 27, 2021 at 9:17AM

Key Points

  • You are paying fees in your 401(k), and those fees are reducing your investment returns.
  • Some 401(k)s have great investment menus, and others do not.
  • 401(k)s have early withdrawal restrictions, which can prevent you from retiring early.

Motley Fool Issues Rare “All In” Buy Alert

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Sometimes, a 401(k) by itself just doesn't cut it.

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.

1. Fees

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.

Younger adult smiling as she reviews paperwork at home.

Image source: Getty Images.

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:

  1. You are an experienced investor who wants specific specialty exposures.
  2. 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.

The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Nearly 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
370%
 
S&P 500 Returns
119%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 12/01/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.