For many working Americans, the 401(k) is the most straightforward way to save for retirement. It's an employer-sponsored plan with much to like, especially if it comes with an employer match, which is basically free money.
So, when I say that there are reasons to avoid a 401(k), it's just that there are drawbacks that might make utilizing more than one retirement account a good idea. Don't go out and cancel your 401(k) plan.
Instead, read this and consider a retirement strategy in which your 401(k) isn't the only plan but a piece of a larger vision.
1. The tax deferrals might be overrated
Tax savings are a popular selling point of 401(k) plans. The money you put into your 401(k) is deducted from your gross pay. That means your 401(k) contributions come right off the top, before state and federal taxes, etc. The result is lower taxable income at the end of the year, so you pay less in taxes.
But the trade-off is that you pay taxes on your 401(k) withdrawals in retirement. In other words, you don't pay taxes on money going in, but you do when it comes out. Suppose your 401(k) did really well, and your retirement withdrawals put you in a higher tax bracket than when you worked. In that case, you could pay more than you had if you never deferred those taxes in the first place.
2. There isn't much to choose from
Employer-sponsored retirement plans like 401(k)s are generally simple. That's both a good and bad thing. For instance, some people lack the information or desire to manage their retirement investments actively. That's why most plans have investment options such as target date retirement funds, which are largely automated plans that allocate portions of your money into various stock and bond mutual funds depending on your age. You might have some other broad options, like large-cap stocks or international stocks.
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The downside is that a 401(k) gives you virtually no flexibility to act on your behalf. What if you want to include some individual stocks in your retirement portfolio? Sorry, at most employers, you're out of luck. Your investment choices are limited to what your 401(k) dictates; some people want more choices.
3. Strict rules for using your money
There isn't much you can do with your money once it goes into your 401(k). That's by design, of course, which keeps people from getting impulsive and draining their retirement for that sweet vacation your friends talked you into. But again, everyone is different, and some may desire flexibility for emergencies or special situations.
Now, the IRS allows plans to authorize early 401(k) withdrawals in cases of financial hardship. However, you'll typically pay taxes for those withdrawals, as well as penalties if you're not yet age 59 1/2. Moreover, the devil in the details is that your 401(k) administrator ultimately has the final say. If your plan doesn't allow early withdrawals for financial hardship, then your money might well be stuck.
Consider including an individual retirement account such as a Roth IRA. A Roth lets you withdraw your contributions (not their gains) without penalty, assuming you meet the requirements. It offers more wiggle room than a 401(k) might.
Wrapping up
To be clear, 401(k) plans do have their perks. And if your plan offers an employer match, it'd be silly not to contribute enough to earn as much free money as you can. After that, it gets interesting. Everyone has different finances, so the rigidity of a typical 401(k) means there's no harm in using more than one retirement account to build your nest egg.
Several additional investment accounts, like Health Savings Accounts, IRAs, and 529 plans, serve different purposes for building a financial future for you and your loved ones while minimizing the taxes you might pay along the way.
