A 401(k) can be an excellent tool to help investors reach their retirement goals. The high contribution limit -- $23,000 in 2024 (or $30,500 for those 50 and older) -- provides most investors with a substantial amount of tax-advantaged savings. Around 15% of all plan participants took full advantage of the generous limits in 2022, according to the most recent data from Vanguard.
But maxing out your 401(k) and ignoring other retirement savings options could be a major mistake. For all the benefits of a 401(k), there are some big downsides you should be aware of.
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Your investment options are limited
Most 401(k) plans offer a limited set of ETFs or mutual funds where you can invest your contributions. While some plans may offer great funds with low expense ratios, most don't. And even when the plan offers low-fee funds, you might prefer a different investment.
The lack of choices may hinder your ability to shape your portfolio as you see fit. If you'd like to keep a significant amount of one asset class, like bonds, in your 401(k), but the plan doesn't offer a suitable fund for that asset class, you're simply out of luck.
Investors who prefer to buy individual stocks over mutual funds and ETFs will have a tough time with a 401(k). Some plans offer self-directed investment accounts, where you're able to buy any investment offered by your brokers (within certain limitations). However, not all employers offer that benefit, and the plans that do typically charge an additional fee.
The fees might not be worth it
Speaking of fees, 401(k) plans typically charge a lot of fees compared to other investment accounts. And those fees can add up fast and eat into your savings.
There are three types of fees you need to be aware of.
- Administrative fees are the fees charged to keep the plan up to date, maintain accurate records, and file the necessary paperwork.
- Service fees are charged on an individual basis for select items like a 401(k) loan or using a self-directed account.
- Investment fees are the fees associated with funds like expense ratios.
The average 401(k) participant at a large company pays 0.85% of their account balance in fees, according to the 401k Averages Book. That percentage is even higher for participants at a smaller company.
Investors can get similar tax benefits by contributing to an IRA instead of a 401(k), but without the fees. Likewise, most brokerages don't charge any fees for using a taxable brokerage account. So, instead of maxing out your 401(k) and paying fees on the entire amount, you might consider only contributing enough to get the company match and using another account for additional savings, especially if your plan fees are higher than average.
401(k)s restrict your withdrawals
A 401(k) is meant for retirement savings. As such, the IRS puts tight restrictions on withdrawals before you reach age 59 1/2. Taking a distribution before that age without a qualifying reason, such as a large medical or educational expense, will result in an additional 10% penalty tax.
There are a few ways around that limit. The Rule of 55 allows you to access 401(k) funds if you leave the workplace in the year you turn 55 or later. But that's only an extra four and a half years. A 401(k) loan allows you to access up to $50,000 of your savings for any reason, but you'll have to pay it back into the plan over time (or immediately if you leave the company).
If you plan to retire early, you probably don't want all of your savings in a 401(k). Again, putting in enough to get the company match is a smart move; then consider putting money into a less restrictive account like a taxable brokerage account or a Roth IRA.
Stay smart with your 401(k)
The 401(k) is a great tool for helping investors reach their retirement goals. If your company offers a matching contribution, you should absolutely max out that opportunity. No investment can offer the immediate returns of a 401(k) match regardless of any fees or restrictions in your 401(k) plan.
But beyond the match, investors should think carefully about where they put their retirement savings if they want to maximize flexibility and minimize fees.
