The 401(k) is one of the most powerful investing tools available in your financial toolbox. With high contribution limits, employer-matching contributions, and automatic enrollment, your 401(k) has plenty of perks to help you save for retirement.
There are some features of the 401(k) that are less than ideal, however, and these three factors could be costing you more than you think.
1. High fees
Everyone pays 401(k) fees, but some accounts charge higher fees than others. The average 401(k) plan charges fees of around 1% of total assets under management, according to a study from the Center for American Progress. That means if you have $100,000 in your 401(k), you'd pay $1,000 per year in fees.
That may not sound like much, but it can add up substantially over time. The average worker paying 1% per year in fees can expect to spend more than $138,000 in fees alone over his or her lifetime, according to the Center for American Progress. If you were paying slightly higher fees of 1.3% per year, though, you'd spend more than $166,000 in fees over a lifetime.
To figure out what you're paying in 401(k) fees, talk to your plan administrator or dig through your plan statements. If you find you're paying more than average, it might be worthwhile to look into investing in an IRA with lower fees instead.
2. Limited investment options
When you invest in a 401(k), you generally only have a few investment options to choose from. These options are pre-selected by the plan administrator, and they typically include a variety of mutual funds.
That's not necessarily a bad thing, but you're missing out on other types of investments that could be earning higher returns. Similarly, if you want more control over your portfolio, it's harder to take a hands-on approach with a 401(k) because of the limited investment options.
IRAs offer more variety than 401(k)s, making them a good choice for someone who wants a more personalized portfolio. Unlike a 401(k), where you're mostly limited to mutual funds, IRAs allow you to invest in everything from index funds to ETFs to individual stocks and bonds.
3. Penalty fees and taxes on early withdrawals
While raiding your retirement fund isn't ideal and should always be a last resort, emergencies happen, and sometimes, you have no choice but to tap into your savings. When you withdraw money from your 401(k) before age 59 1/2, however, it will result in a 10% penalty fee and income taxes on the amount you take out.
Early withdrawals could also pose a problem if you plan to retire early. If you retire at age 55 or later, there's an exception to the penalty, and you won't have to pay the 10% fee. But if you retire before age 55, you'll still face penalties for early 401(k) withdrawals, which can quickly eat into your savings.
To avoid early withdrawal penalties, you may opt to invest at least some money in a Roth IRA. With a Roth IRA, you'll pay taxes on your contributions but not on your withdrawals. So if you're forced to tap into your savings in an emergency or you retire early, you can generally avoid taxes and penalties.
When should you invest in your 401(k)?
Although 401(k)s have their downsides, that doesn't mean you should avoid this type of account altogether. If your plan offers employer matching contributions, it's wise to save enough to earn the full match. After all, matching contributions are essentially free money.
In addition, 401(k)s have much higher contribution limits -- $19,500 per year in 2021, compared to just $6,000 per year for IRAs. So if you max out your IRA, you may choose to invest the rest of your savings in your 401(k). Even if you're paying high fees or don't have access to the types of investments you'd prefer, it's still better than saving nothing at all.
Investing in a 401(k) is a fantastic way to save for retirement, but be sure you're aware of its pitfalls. By knowing the limits of this type of account, you can ensure you're making the best decisions for your situation.