Gone are the days when employees could work for the same company for years on end and have a pension to look forward to in retirement. These days, most major companies don't offer pensions (last year, only 16% of Fortune 500 companies did), leaving employees with no choice but to turn to other savings options, such as the 401(k).
A 401(k) is an employer-sponsored plan that enables workers to save for retirement in a tax-advantaged fashion. With a traditional 401(k), your contributions go in tax-free, and withdrawals are taxed in retirement. With a Roth 401(k), you don't get a tax break on contributions, but your investments grow tax-free, and withdrawals aren't taxed in retirement. Both types of 401(k) are extremely useful in helping workers amass funds for the future, but they aren't perfect. Here are three problems you should know about.
1. Individuals bear investment risk
Employers who offer pensions must invest those funds to ensure that there's enough money to pay employees their retirement benefits once they're eligible to receive them. But when you save in a 401(k), it's on you to choose investments that allow your money to grow. As such, you, as an individual who may not know much about investing, assume all of the risk involved so that if the funds you pick for your 401(k) perform poorly, you risk not having access to enough income in retirement.
2. High fees
Employer-sponsored 401(k) plans come with fees that can eat away at your savings' growth. All plans come with administrative fees, which are typically passed on to you, the individual saver. In addition, you'll pay fees for the specific investments you choose within your account.
3. Not everyone has access to them
An estimated 35% of private-sector employees don't have access to a 401(k) through their companies, according to data by The Pew Charitable Trusts. And that lack of availability is higher among younger workers -- 41% of millennials don't have a 401(k) through their jobs.
An imperfect solution
Clearly, 401(k)s aren't the flawless retirement-savings solution many of us would like them to be. On the other hand, they do offer a number of key benefits. For one thing, they come with generous annual contribution limits. Beginning in 2019, savers under 50 will have the option to sock away up to $19,000 a year in a 401(k), while those 50 and older will get to set aside up to $25,000. There's also the potential for employer matching dollars, which is akin to free money for your golden years.
That's why it pays to participate in your employer's 401(k) if the option to sign up exists. That said, so do wisely. Diversify your investments within your account to protect yourself from needless risk, and factor your age into your strategy. If you're younger, you can afford to go heavy on aggressive, stock-focused funds. If you're close to retirement, though, you should really scale back in that area and load up on safer investments instead. Additionally, pay close attention to investment fees and choose index funds over actively managed mutual funds to lower yours.
Finally, if your employer doesn't sponsor a 401(k), look into opening an IRA. Though IRAs come with substantially lower annual contribution limits, if you max one out over time, you can accumulate a significant sum for retirement. And as a bonus, they tend to offer a wider range of investment choices than most 401(k)s. Of course, you'll still have to bear the aforementioned investment risk yourself, but if you're smart about diversifying and adopt a well-thought-out strategy, you can be successful and accumulate enough wealth to retire comfortably.