When it comes to retirement accounts, none are as popular and widely used as the 401(k). That's to be expected, though, considering the convenience and tax benefits. While the tax benefits and perks like an employer match after often emphasized, a 401(k) also has some drawbacks that make it a bit overrated.
Here are three reasons to think twice before relying solely on a 401(k) for your retirement savings.
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1. 401(k)s are typically more expensive than other options
One major downside of a 401(k) can be expensive fees. There are three broad types of fees associated with a 401(k): administrative, investment, and service. Your plan provider charges administrative fees for things like bookkeeping and maintaining your account; the specific funds you invest in charge investment fees; and service fees are charged for any additional services you may choose, such as a 401(k) loan.
Many people aren't even aware they're paying 401(k) fees, let alone how expensive they are. Total 401(k) fees can easily reach the 0.5% to 2% mark, which may seem small on paper, but it really adds up. For example, if you average 7% annual returns over 35 years, a 1% difference in fees could end up reducing your balance by around 28%.
That's a large chunk of change that could be used in retirement instead of paid toward fees.
2. Limited investment options
An important part of investing is making sure your investments fit your risk tolerance and financial goals.These vary widely, so the specific investments people are interested in also vary widely. Income investors usually aren't interested in the same stocks as growth investors, for example.
Unfortunately, your investment options are provided for you in a 401(k). The options are typically your company's stock (if they're a public company), market cap-based funds, an international fund, and target-date funds that automatically reallocate to become more conservative as you near retirement.
For some people, the fewer the options the better, so a 401(k) works perfectly fine. For others who want to be more hands-on and tailor their investments to fit their specific needs, the provided options may not suffice.
Conversely, IRAs work similarly to brokerage accounts in that you can invest in any individual stock or exchange-traded fund you choose. Whether it's a major index, blue chip stock, or "the next big thing," you have the option to invest in it in an IRA.
3. Less lenient withdrawal policies
Since a 401(k) is a retirement account, it has withdrawal rules in place to discourage someone from taking money out of their account before retirement. These rules are effective because they stop people from treating their 401(k) like a regular savings account, but they can also be restricting when life happens.
Making an early withdrawal from your 401(k) will impose a 10% fee on the withdrawn amount. There's also a 10% early withdrawal fee for IRAs, but more exceptions are granted with this account. For example, you can withdraw up to $10,000 from an IRA to put toward the purchase of your first home. You can't do that with a 401(k).
There are also required minimum distributions (RMDs) you must start taking once you turn age 73 (it was 72 prior to this year). As the name suggests, RMDs are withdrawals you must make to avoid a penalty.
If you don't take your RMDs when you're supposed to, you'll be penalized 25% of the amount not withdrawn. For instance, if your RMDs for the year are $10,000 and you only withdraw $4,000, you'd owe an additional $1,500 tax (25% of the $6,000 left). The IRS notes this penalty could possibly get reduced to 10% if you fix the problem within two years.
Traditional IRAs also have RMDs, but Roth IRAs don't. You can hold on to your Roth IRA investments as long as you live, which can be an advantage in growing wealth. Imagine someone has a Roth IRA worth $800,000 by the time they're age 72. If they don't make another contribution and average 8% returns until they turn 80, they'll have over $1.4 million.
