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3 Drawbacks of Using Only a 401(k) for Retirement

By Ryan Downie - Mar 11, 2021 at 9:20AM

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Find out why you should consider stashing your retirement savings in brokerage and Roth accounts, in addition to your 401(k).

401(k) accounts are a great tool for savers who want to supplement Social Security income in retirement. It's a great idea to take advantage of the employer matches and automated savings provided by this account. However, you might want to consider a more balanced approach if you're contributing above and beyond the employer match.

Everyone's situation is different, but there are definitely some situations where the 401(k) isn't the only place you should be parking your retirement savings.

1. Taxes in retirement

People love the idea of avoiding taxation today, and that's one of the qualities that make 401(k) accounts so attractive. Qualifying contributions are made and grow on a tax-deferred basis. That's great, but you have an embedded liability that grows over time. Withdrawals will be taxed as ordinary income in retirement.

Eggs with "IRA", "Roth", and "401k" written on them, sitting on bed of money.

Image source: Getty Images.

The prevailing wisdom is that people will occupy lower tax brackets in retirement than they do during their working life, and that's usually how it plays out. In retirement, you'll no longer need the same income to replicate your lifestyle. You won't need to set aside a portion of your income for savings, there most likely won't be housing payments or kids to take care of, and Social Security will also send checks each month. That's all working in your favor.

Two key issues arise from those assumptions, however. First, lower tax brackets in retirement don't necessarily mean lower tax rates. Many Americans are confident tax rates will be higher in the future due to consistent deficit spending among federal and state governments. At some point, what is borrowed must be repaid. If tax rates are meaningfully higher in a few decades, it might be unwise to delay taxation.

Second, it's pragmatic to forecast lower income in retirement, but that doesn't mean that you should aspire to occupy a lower tax bracket. Whether you're preparing for healthcare costs and longer life expectancy or just trying to embrace a great lifestyle during those years when "every day is Saturday," you might have to prepare for higher income.

The solution here is balance. Spreading your retirement savings across different types of accounts will diversify your tax exposure. Consider using a Roth IRA if you can, which will provide tax-free distributions. You can also use a regular brokerage account for long-term growth, and that would be taxed at long-term capital gains rates rather than ordinary income rates. These are viable complements to your 401(k), especially if you're a young person with dependents or deductible interest from mortgages or student loans.

2. Poor liquidity

Once your money goes into a 401(k), it's generally only coming out before you turn 59 1/2 if you pay a 10% penalty. There are exemptions for first-time homebuyers or those encountering financial hardship, but you shouldn't plan for them unless it's opportunistic. Your 401(k) should be invested with a specific time horizon in mind, and that influences the amount of volatility that's appropriate. If you're planning to access those funds in a shorter time frame, then your allocation isn't going to match your goals.

Ultimately, you're locking yourself out of your money for a long time when it goes into a 401(k). That might be a blessing for people with bad savings habits, but that money is also unavailable when an emergency or opportunity arises.

Again, Roth and brokerage accounts are good ways to balance growth and liquidity. Stocks in a brokerage account can generally be sold and withdrawn in a matter of days (though it might be a taxable event if you have gains). Because Roth contributions are made after-tax, you can withdraw up to the amount you've deposited without incurring a penalty. Accessing gains in a Roth account is a different story, but that's still more flexible than a 401(k).

3. Investment options & fees

Your 401(k) is subject to the terms and investment options provided by your employer's plan. Many 401(k) plans have plenty of mutual fund and ETF options that will do a fine job for any retirement saver. Still, you generally won't be able to purchase individual stocks. Opening a traditional IRA, Roth, or brokerage account on any of the popular platforms will open the door to thousands of potential investments, including your favorite stocks or niche ETFs for growth or dividends.

You also have no control over fees in a 401(k). Those are negotiated by your employer, and smaller plans can carry relatively high management fees. There are regulations in place to keep these from being exorbitantly high, but you might be paying more than you would with a popular brokerage platform.

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