Your employer 401(k) plan is a powerful tool, and there are plenty of advantages to contributing to one as you're saving for retirement. Especially if your employer offers matching contributions, saving in a 401(k) is a no-brainer.
However, there are other types of retirement accounts out there, and they have their advantages as well. While the 401(k) certainly has its place, there are a few downsides to only contributing to this type of retirement account. Here are three to be aware of.
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1. You don't have as much control over your investments
When you contribute to a 401(k), you're generally stuck with the specific types of investments your plan offers. Typically, this means you have a handful of mutual funds from one investment company to choose from. While this isn't necessarily a bad thing for many investors, it can pose a problem for those wanting more control over where and how their money is invested.
With an Individual Retirement Account (IRA), you have far more options when choosing where to invest your money. You can invest in various mutual funds, or you could also invest in individual stocks or bonds, exchange-traded funds (ETFs), or certificates of deposit (CDs). Because IRAs generally offer a much wider selection of investment options than 401(k) plans, that makes them a good choice for those who want to take a more hands-on approach when saving for retirement.
2. You could be paying higher-than-average fees
Pretty much all retirement accounts managers charge fees, so no matter where you invest, you won't be able to escape them entirely. But because you're limited to the investment options your plan offers when contributing to a 401(k), you may also be stuck with higher fees.
The average 401(k) plan charges an annual fee of around 1% of total assets managed, according to a report from the Center for American Progress. In other words, if you had $100,000 in your 401(k), you'd pay $1,000 per year in fees.
Even slightly higher-than-average fees can add up over time, too. The average worker paying 1% in annual fees can expect to pay around $138,000 in fees over a lifetime, the Center for American Progress found. If the annual fees were bumped up to just 1.3%, the lifetime fees would jump to more than $166,000.
If your 401(k) is charging higher-than-average fees, you may not be able to do anything about it. But because IRAs offer a much larger selection of investments, you may be able to reduce your fees by investing in another type of retirement account.
3. You're missing out on potential tax advantages
401(k)s are considered a tax-deferred type of account, meaning you get a tax deduction when you make the initial contribution, but you'll owe taxes on your withdrawals in retirement. Traditional IRAs are tax-deferred as well, but Roth IRAs work the opposite way: You pay taxes on your contributions upfront, but then your withdrawals are tax-free.
Investing in a Roth IRA can be a wise move if you want to reduce your taxable income in retirement. It can also be a little easier to plan for retirement when you invest in a Roth IRA. Since you won't have to account for taxes taking a bite out of your savings, the amount in your account is the amount available to spend in retirement.
Just keep in mind that those earning more than $139,000 per year (or $206,000 per year for married couples filing jointly) are not eligible to contribute to a Roth IRA, although it is possible to make backdoor Roth IRA contributions if your income is over the limit. In addition, you're only eligible to contribute up to $6,000 per year in a Roth IRA (or $7,000 per year if you're age 50 or older). So if you're a super saver, you might need to take advantage of another type of account in addition to an IRA.
When should you invest in a 401(k)?
All of this isn't to say that your 401(k) is not a good choice when saving for retirement. The 401(k) has its perks, too, particularly those employer-matching contributions. So in many cases, the best option may be to take advantage of multiple retirement accounts.
For example, if your 401(k) charges high fees, you may choose to contribute just enough to earn any matching contributions from your employer, then stash the rest of your cash in an IRA. Or if you want to reduce your taxes right now and in retirement, you may opt to save in both a 401(k) and a Roth IRA. If you expect to stash a lot of cash in your retirement account each year, you may choose to max out your IRA and then put the rest in a 401(k). The annual contribution limit for 401(k)s is $19,500, so if the $6,000 per year limit for IRAs isn't enough, your 401(k) can allow you to keep saving.
All retirement accounts have their advantages and disadvantages, and the 401(k) is no exception. While it's a wonderful option that has its bright spots, you could be missing out by avoiding other types of retirement accounts.
