They were hailed as a much-needed option when they were first introduced in 1978. Not only did they take the pressure off increasingly struggling pension funds, but they offered workers more personal control of their retirement savings.
As time has marched on and people have become savvier investors, however, 401(k) plans have lost at least some of their luster. Here's a closer look at four of the top reasons you might not want to participate in such a work-sponsored plan and instead contribute that money to a self-directed retirement account.
1. Traditional 401(k) money is taxed when withdrawn
You're always going to pay taxes on work-based income. It's just a matter of when, and how.
The stark difference between Roth IRAs and traditional IRAs offers us an example of this reality. While traditional IRA contributions typically reduce your taxable income for the tax year they're made, withdrawals from these accounts are taxed as income. Conversely, Roth IRA contributions don't provide any sort of tax break while contributions are being made to the account. But, that money comes out tax-free (assuming the laws don't change in the meantime).
The same rules apply to most 401(k) contributions. That is, these contributions are deducted from your taxable earnings while they're being deposited into your 401(k) account, but all of any money removed from a 401(k) is treated like taxable income as it's taken out. If your 401(k) account is large enough -- and your withdrawals are subsequently big enough -- it's possible you could be paying more in taxes in retirement than you would have paid by not making these tax-deductible contributions while working.
Although you can't predict future tax rates, you should still seek to minimize the tax bill related to your retirement savings to the best of your ability. That may actually mean paying taxes now.
With all of that being said, do know that employers are increasingly offering Roth 401(k) accounts as part of their retirement benefits package. You'll want to make a point of paying close attention to all your when you enroll in such to make sure you're maximizing your bottom line when it matters the most.
2. Your investment options are usually limited
The nice part about opening a traditional IRA or Roth IRA account with a broker is that you can hold any security you want within it. Stocks, bonds, funds, or a mix of these investments are all options. As such, you've got more options to generate growth.
That's not the case with the vast majority of 401(k) plans. With most 401(k) plans, your investment options are limited to one fund company's or brokerage firm's own mutual funds. Indeed, you may not even have access to all of their fund options.
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And that's not a problem to simply dismiss. Standard & Poor's continually updated report card on mutual funds offered to U.S. investors finds that the majority of them consistently underperform the S&P 500 (^GSPC 1.02%). If you've already got money committed to a company-sponsored 401(k) plan, statistically speaking, your best bet is its most broad-based index fund.
3. You could pay higher fees
As the old adage goes, there's no free lunch on Wall Street. With the advent of the web and the continued reduction in brokerage firms' expenses, though, lunch on Wall Street can be pretty cheap these days. Commission-free trading is common now, and mutual fund companies are using their low expense ratios as a top marketing tool. Annual account fees are also pretty much a thing of the past.
Company-sponsored retirement plans, however, haven't exactly followed suit. Most 401(k) plan managers charge a management fee ranging from 0.5% to 2% of the plan's total pool of assets. That's above and beyond any funds' expense ratios. This fee ultimately reduces your overall returns, particularly if you continue to contribute to the plan for several years.
There is one bright spot in this regard. It's possible your employer covers these administration costs rather than putting that burden on workers, and workers' retirement accounts. Hopefully that's the case for you.
4. Your employer's contribution may not be yours right away
Last but not least, know that while an employer's contribution of additional money to your 401(k) plan is a compelling perk, that may not be your money right away. While this is less common now than it used to be, some companies still use a vesting schedule that gradually makes that money yours over the period of several years.
It's fair enough. After all, it's free money meant to encourage employee longevity. If you leave a job after a short time, your company's investment in you is a bit of a bust.
Nevertheless, too many people have left jobs after a short while only to learn that not all of their 401(k) balance is coming with them.
Connecting the dots
Don't misunderstand. There are still plenty of good reasons to participate in your employer's 401(k) plan. Your company's contribution match is one of them, especially if you intend to remain at that job for several years. Your likely taxation scenario in the future may also be one that favors the bigger, tax-deductible contributions you can make to a 401(k) now. Your company's plan might have relatively low fees as well.
401(k) plans are far from being the perfect retirement vehicle for everyone, however. And they may not be enough of a retirement savings option by themselves to maintain the standard of living you enjoyed while you were working after you've stopped earning work-based income.
For most workers/investors, rather, the ideal solution is a mix of all your options. If your company offers matching up to a certain amount of your own personal contributions, by all means contribute enough to max out that free money. And if you know you're not going to contribute to a self-directed IRA outside of your employer's plan, you may as well participate in your work-based plan to the fullest extent possible; something's better than nothing.
But there's nothing to prevent you from supplementing this savings by contributing to your own Roth or traditional IRA every year. These added options will also let you hedge your future taxation bets.
The key is just spending a few minutes making a budget that optimizes and maximizes your retirement savings contributions, and then spending a few more minutes putting those plans into action with your employer's plan provider and a brokerage firm. It's well worth the effort.
