A 401(k) is a great resource for saving and investing for retirement. Not only does it help you set aside money for your financial future, but it also helps you save money in the present by lowering your taxable income -- a win-win.
The more you save for retirement the better, but it's also important to understand your different options and which may suit you best. Before you decide to try maxing out your 401(k), here are a few unfortunate truths to know.
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You may be settling for poor investing options
One of the drawbacks of a 401(k) plan is the limited investment options. You can't make any investment you want. Instead, your plan provider sets the options you can choose from. These usually include your company's stock if it's a public company, target-date funds (funds that automatically rebalance as you near retirement), and market cap-based funds.
The investment options don't matter for some people, because they're perfectly content with limited options. For others, the limited options may prevent them from executing their investing strategy. For example, if you wanted to invest in a more industry-specific exchange-traded fund (ETF) like the First Trust NASDAQ Cybersecurity ETF, many 401(k) plans wouldn't let you.
That's where an IRA comes in handy. Roth and traditional IRAs are retirement accounts that operate like regular brokerage accounts, in that you can invest in any stock you want. Whether it's individual companies, index funds, or ETFs, there's no shortage of options.
With a Roth IRA, you contribute after-tax money and can take tax-free withdrawals in retirement. With a traditional IRA, you can deduct your contributions, depending on your income, filing status, and whether you're covered by a retirement plan at work (such as a 401(k)). Unlike a Roth IRA, traditional IRA withdrawals are taxable.
The contribution limits for IRAs are much lower than those for a 401(k) -- $6,500 ($7,500 if you're 50 or older) in tax year 2023 -- so they're not as useful for those who want to save a lot toward retirement. But if you want to make investments not offered by your 401(k), they can be a great choice considering the potential tax breaks.
You could be spending more in fees than you realize
When I talk to people about their 401(k), one thing a lot of people are shocked about is just how much they're paying (or will end up paying) in fees. There are generally three types of 401(k) fees: administrative, investment, and service.
Your plan provider charges administrative fees for maintaining your plan, which can range up to 2% in some cases. Investment fees are charged by the funds you invest in with your 401(k). For example, if you invest in three different index funds, you'll pay the expense ratio for each fund. Both administrative and investment fees are charged as a percentage of your total investment.
Here's approximately how your account value would differ by fees if you invested $500 monthly for 25 years, averaging 8% annual returns:
| Total Fees | Value After 25 Years | Amount Paid In Fees |
|---|---|---|
| 1% | $379,494 | $59,141 |
| 1.5% | $353,326 | $85,309 |
| 2% | $329,187 | $109,448 |
Data source: author calculations
What may look small on paper can really add up over time and be costly, so always be mindful of just how much you're paying for your 401(k). You may find that cheaper investment options -- like index funds instead of target-date funds -- may be better suited for you.
It's not realistic for most people
For tax year 2023, the maximum contribution to a 401(k) plan is $22,500 ($30,000 if you're 50 or older). Considering the median U.S. household income is just above $67,500, it's safe to say maxing out a 401(k) is unrealistic for most people -- and that's perfectly fine. The goal is to save for retirement without threatening your current livelihood.
If you can max out your 401(k), perfect. If you can't, the minimum you should be contributing (assuming you have the financial means) is the maximum amount your employer will match. If they match 3%, make 3% your minimum; if they match 5%, make 5% your minimum. An employer match on your 401(k) is as close to "free" money as there is, and you don't want to leave any on the table by shortchanging your contributions.
