One of the best things anyone can do to prepare financially for retirement is to use retirement accounts because they provide a two-for-one benefit. In addition to letting you actively save and invest for retirement, they offer tax breaks along the way.
The most common retirement account is a 401(k), mainly because it's offered through employers. It's convenient to set up, allows employers to match contributions, and gives people a hands-off approach. However, some downsides to a 401(k) shouldn't be overlooked. Here are three reasons to avoid a 401(k) for your retirement savings.
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1. Your investment options will be limited
One of my biggest concerns with a 401(k) is the limited investment options. Unlike IRAs, most 401(k) plans come with a pre-selected list of index funds, mutual funds, stocks, and bonds your plan provider chooses.
For investors who struggle with analysis paralysis, the limited options may be ideal. For investors who want to tailor their portfolio to match their financial goals and risk tolerance more accurately, the limited options can be hindering.
Flexibility is a key part of investing, and many investors will find that they don't have that with a 401(k). Investors may want to invest in a specific company, industry-specific fund, or a certain kind of stock like real estate investment trusts (REITs) but find they're not available through the plan. If that's the case, a 401(k) isn't the ideal route.
2. The withdrawal rules aren't lenient
When you contribute to a retirement account, it should be with the intention of keeping the money there until retirement -- that's the purpose. However, life happens -- emergencies and unforeseen circumstances sometimes require you to tap into your retirement savings.
Generally, an early withdrawal from a retirement account (both 401(k)s and IRAs) before the age of 59 1/2 sparks a 10% early withdrawal penalty, as well as taxes on the withdrawn amount. There are exceptions to this rule for specific retirement accounts, but 401(k)s are far more strict when it comes to exceptions to the withdrawal penalties.
Here are a few exceptions, for example, that apply to an IRA but not a 401(k):
- Education: Money can be used for qualified higher education expenses for you, your spouse, or your children.
- First-time homebuyer: Up to $10,000 can be withdrawn to put toward a first home purchase.
- Health insurance: Money can be withdrawn to pay for health insurance premiums during periods of unemployment.
Additionally, required minimum distributions (RMDs) mandate that you start withdrawing a certain amount from your 401k once you reach the age of 73, whether you need the money or not. This could potentially push you into a higher tax bracket and increase your tax bill.
3. They can be more expensive than you realize
For even the most knowledgeable 401(k) plan participants, the one thing that can fly under the radar is just how expensive a 401(k) can be. Generally, there are four broad types of 401(k) fees:
- Administrative: Fees that cover day-to-day operations and plan maintenance.
- Investment: These are fees charged by your specific investments, similar to expense ratios for exchange-traded funds.
- Individual services: Fees related to optional services like taking out a loan.
- Plan services: Fees associated with services offered such as advisors and educational seminars.
401(k) plan fees vary based on factors like an employer's size, the number of people participating in the plan, and the plan provider. But generally, it can cost anywhere between 0.2% to 2% of your total investment amount annually. Although those percentages may seem small on paper, they add up, especially down the road when people's account balances tend to be much higher.
This isn't to say that 401(k)s aren't worth the fees. For a lot of people, they absolutely are. The more important thing is to be knowledgeable about your fees, so you can make informed decisions about your retirement savings strategy and make sure the benefits you reap are worth the cost.
