When it comes to retirement accounts, the 401(k) is far and away the most popular option. Since it became active in January 1980, the 401(k) has helped millions of Americans build a retirement nest egg designed to sustain them in their golden years.
There's no denying that a 401(k) is an effective way to save for retirement. It's passive, there are employer matches, and it comes with tax breaks. That said, I also believe a 401(k) can often be overrated. Here's why.
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The provided investment options may not fit your preferences
Retirement is a personal journey, so a cookie-cutter approach typically doesn't work for many people. People have different retirement and financial goals, time horizons, and risk tolerance, so flexibility is key.
With a 401(k) account, this flexibility is limited because your investment options are provided to you. The investment options will vary by plan, but it's generally your company's stock (if it's publicly traded), market cap-based funds (small, mid, large), and target-date funds, which are based on your projected retirement year and automatically rebalance as you near retirement.
If you're comfortable being hands-off and leaning on the given options, 401(k) investment options might not be a problem. If you'd prefer to tailor your investment to fit your specific needs, the provided options might not do the trick.
In IRAs, you can invest in any individual stock or exchange-traded fund (ETF) that you could in a standard brokerage account (some have exceptions for higher-risk investments like options). Whether it's an emerging growth stock, industry-specific ETF, or specific international markets, you can ensure your investments align with your goals and risk tolerance.
Most 401(k)s have required minimum distributions
With a traditional 401(k), you receive your tax break on the front end, with your contributions reducing your taxable income. However, if you know Uncle Sam, you know he wants his money at some point. To avoid a situation where someone contributes to a 401(k), gets the tax break, and never makes withdrawals, the IRS implemented required minimum distributions (RMDs). They also apply to traditional IRAs, because your tax break is on the front end with those as well.
RMDs begin the year you turn age 73, but you can delay taking the first RMD until April 1 of the following year. For example, if you turn 73 in 2024, you could delay your RMD until April 1, 2025. If you don't take RMDs by your deadline, the amount that was supposed to be withdrawn will face a 50% excise tax. The IRS notes that this excise tax could be dropped to 10% or 25% if the RMD is corrected within two years.
In Roth IRAs -- and Roth 401(k)s as of the start of 2024 -- there are no RMDs. Since you've already paid taxes on the money you contribute to a Roth IRA or Roth 401(k), the IRS doesn't double-tax you with another set of taxes owed in retirement. This is a great benefit because your investments get to grow and compound tax-free, easily saving thousands in taxes for many people.
Not having RMDs also gives someone more time to let their investments compound and then pass them on to a beneficiary when they pass away. This could be a huge wealth accumulation and transfer benefit.
401(k) fees can be expensive compared to IRAs
Since 401(k)s are employer-sponsored, there are more administrative logistics the plans must account for. From recordkeeping to legal to trustee management to compliance, 401(k) plan administrators have many responsibilities. Unfortunately, many of these costs are passed down to employers via administrative and other fees.
There are three broad types of fees that you can face with a 401(k): Administrative, service, and investment. With an IRA account, the only one of those fees you'll typically face is investment, which is essentially the expense ratio charged by funds you invest in.
Even an additional 1% in fees can have a noticeable effect on your account throughout a career. If you invested $500 monthly and averaged 10% annual returns (after fees) for 30 years, you'd have just under $987,000. Adding an extra 1% fee over that span would bring your total down to just under $818,000. Fees matter.
Being overrated doesn't mean you should avoid it
Although the 401(k) has its cons, if you have the opportunity to take advantage of one, you absolutely should. If anything, the 401(k) shortcomings should be a reminder of why it's important to use multiple resources to prepare financially for retirement.
It's infinitely better to be overprepared than underprepared, so diversify your retirement strategy with a 401(k), IRAs, and investments. You'll likely be glad you did.
