One thing's for sure regarding retirement savings: The earlier you begin, the better. Time and compound earnings are some of the greatest wonders in the investing world, and their impact can't be overstated. Using retirement accounts is one of the most productive ways to do it.
There are a handful of retirement accounts available, but none are as popular as the 401(k), mostly because it's offered through employers. A 401(k) allows people to set aside pre-tax money, enabling you to save for retirement while lowering your taxable income for the year.
Although millions of Americans rely on a 401(k), and it's a great resource, it's also overrated in my book. Let's take a dive in and see why.
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Freedom of investment choices matters for many people
One of the biggest drawbacks of a 401(k) is its limited investment selection. Whenever you have a 401(k), your plan provider gives you set investment options that you have to choose from. Generally, the options are your company's stock (if it's a public company), market cap-based funds (small, mid, large), bonds, and target-date funds, which automatically rebalance themselves as you get closer to retirement.
Although these investment options may be sufficient for some, they can be limiting for many others who'd prefer to be able to tailor their investments to better suit their investment goals, risk tolerance, and retirement time horizon.
Imagine you're interested in an emerging industry, such as artificial intelligence or electric vehicles. If you wanted to invest in an ETF that focused on those industries, you likely couldn't in your 401(k). If you wanted to buy Microsoft shares in your 401(k), you wouldn't have the option unless you worked for the company or got them through one of the provided fund options.
Conversely, IRAs don't have these limited investment options. With an IRA (of any type), you can invest in any stock or fund that you could in a traditional brokerage account. From specialized ETFs to high-flying stocks, there are countless options to ensure your portfolio truly matches you.
A 401(k) isn't very forgiving to those who need to make early withdrawals
You don't want to contribute to a retirement account with the intention of withdrawing your funds before retirement, but... life happens. Unexpected emergencies happen, and sometimes, tapping into your retirement accounts is the only way to access the funds you need.
With a 401(k), making an early withdrawal will result in a 10% early withdrawal penalty and owed taxes on the withdrawn amount (since you didn't pay taxes on the initial contributions).
The same 10% penalty applies to early withdrawals from a traditional IRA because the funds contributed are pre-tax and haven't been taxed yet. A Roth IRA, on the other hand, doesn't have this penalty because you contribute after-tax money into the account. You can withdraw your contributions -- but not earnings -- at any time, penalty-free.
IRAs also have more exceptions to the 10% early withdrawal penalty. Below are exceptions to the early withdrawal penalty that applies to IRAs but not a 401(k):
- Home buying: First-time homebuyers can withdraw up to $10,000 from their IRA to purchase a home. This money can be used for a down payment, realtor fees, or closing costs.
- Education: You can withdraw from an IRA for qualified higher education expenses, including tuition, books, student fees, and other mandatory fees associated with enrollment. A notable exclusion is room and board.
- Health insurance: If you're unemployed, you can use funds from your IRA to pay for your health insurance premiums.
Having the option to use your retirement account for those life events offers you flexibility to navigate major events and unforeseen circumstances.
Overrated doesn't mean it's not a good option to use
Regardless of the cons of a 401(k), it's still a great resource for retirement savings. It's passive (which many people prefer), offers the chance for employer matches, and provides tax breaks. A true trifecta, if you will.
If anything, the shortcomings of a 401(k) should be another example of why it's important to attack retirement savings from multiple angles. Use a 401(k), IRA, and brokerage account in tandem to ensure you're as financially prepared for retirement as possible. There's no such thing as taking advantage of too many resources.
