Having the option of investing in a 401(k) plan is a blessing for many people; in the short term, you get to lower your taxable income and save money on taxes, and in the long term, you put yourself in a position to live financially comfortably in retirement. Using a 401(k) is one of the best things anyone can do to protect their financial future.
However, a 401(k) is not without its drawbacks. Here are three surprising downsides to investing in a 401(k).
1. The investment options are limited
Unlike a brokerage company or IRA, you can't count on being able to invest in any single company or fund of your choice in a 401(k). Whoever your plan provider is will give you the investment options you can choose from. These typically include your company's stock (if they're public), target date funds based on your projected retirement year, funds grouped by market cap, and likely an international fund. Options vary by plan, but you can generally expect to see those.
Only having a handful of options to choose from can be limiting for people who want a bit more control over their investment choices.
2. The costs are higher than you may realize
401(k) fees can be on the more expensive end because they have a few layers. First, you'll face plan administrative fees, which go to your plan provider for all the necessary administrative things like record keeping, trustee services, and accounting. It will also cover any additional activities your plan offers, such as educational seminars and other services.
Next, you can expect to pay investment fees, which make up the bulk of 401(k) fees. They're charged as a percentage of your invested amount and vary by fund. For example, a 0.50% expense ratio would mean you'd get charged $50 per $10,000 you have invested. If the fund is actively managed, the fees are likely to be higher, as is the case with target date funds, which are reallocated to become more conservative the closer you get to retirement.
There is also a chance your plan charges extra for other individual services. Besides the standard buying and selling, you could face service fees for things like taking out a loan from your plan, rolling over your 401(k) into a different plan, or seeking out financial advisory help. Before doing those things, double-check with your plan to see if and how much it may cost you.
3. Early withdrawal options are limited
One thing about a 401(k) plan is it tries to do as much as possible to deter you from withdrawing any money before retirement. This isn't necessarily a bad thing, but you see just how limiting it can be compared to retirement accounts like IRAs. Both account types will face a 10% early withdrawal penalty, but there are more exceptions with IRAs.
Money can be withdrawn from an IRA for qualified higher education expenses for you, your children, spouse, or grandchildren without penalty. First-time homebuyers can also withdraw up to $10,000 to put toward the cost. And you can even withdraw from an IRA to pay for health insurance premiums while you're unemployed. None of those things are possible with a 401(k) without facing the 10% early withdrawal penalty (and income taxes on the withdrawn amount).