You should always want to take advantage of the resources and different accounts designed to help you save and invest for retirement. Part of doing this efficiently is understanding the benefits and drawbacks of each. Most people are familiar with a 401(k) plan because it's offered through their employer, but other accounts provide their own unique benefits that you should take advantage of.
Here's why your 401(k) is overrated, and you should focus on a Roth IRA instead.
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A 401(k) can be limiting and costly
A 401(k) is a great tool to save and invest for retirement, but it's not without its limitations. First, you can't freely invest in whatever stock you want in a 401(k); your plan provider gives you the options to choose from. Generally, the options will include your company's stock (if it's public), funds put together based on market cap and international companies, and target-date funds.
As time has passed, the popularity of target-date funds has increased, with people holding a target-date fund rising from 19% in 2006 to 56% in 2018. The drawback with target-date funds, however, is that because they're actively managed, they're usually costlier than other investment options. At an average cost of around 0.50%, you'd be paying $50 per $10,000 you have invested.
A 401(k) plan also has required minimum distributions (RMDs). Since you got your tax break up front, Uncle Sam expects to be paid at some point on the back end, and this is done through RMDs. Once you turn 72, you're required to begin taking taxable distributions from your 401(k), and if you don't take your RMD, you have to pay a 50% tax on any required amount that was not distributed.
Use a Roth IRA if you're eligible
A Roth IRA has more freedom because you can invest in any stock you could purchase through your regular brokerage account. With this freedom comes the option to invest in any company you want and low-cost index funds. It might not seem like much on paper, but even a drop in the smallest percentages could save you thousands in the long run.
If you manage to accumulate $1 million in a fund (which isn't farfetched for people making consistent contributions over the years), the difference between a 0.50% and 0.05% expense ratio is $4,500 per year just in fees. And that doesn't even include the difference in fees you paid annually getting to the $1 million mark.
Since you contribute after-tax money into a Roth IRA, you get to take tax-free withdrawals in retirement. You're also not required to take distributions at a certain age; you can let your account grow and compound as long as you please. If it turns out you don't need the money in your Roth IRA, you can even pass it on to your kids (although they have to take distributions at some point). This is a good tool to help build family wealth when used the right way.
A contribution path to follow
You want to always contribute up to your employer match in a 401(k) because that's essentially an automatic 100% return on your contributions. You also want to take advantage of a Roth IRA while you're still eligible. At some point, you might find that you earn too much to be eligible, so take advantage of it while you possibly still can.
Ideally, if you're prioritizing which accounts to contribute to, you'd follow this path:
- Contribute the most your employer will match to your 401(k) -- and not a penny less.
- Contribute the maximum contribution allowed to a Roth IRA.
- Return to your 401(k) and maximize those contributions (if possible).
Using that strategy can help you take advantage of the best of both worlds. You get the employer match and a chance to lower your taxable income for the year with your 401(k) contributions, as well as the freedom that comes with a Roth IRA. Of course, not everyone will be able to max out both accounts, but using them both to take advantage of their benefits is a great way to set yourself up for retirement.
