The 401(k) is one of the simplest ways to save for retirement. Once you set up your contribution amount and your investment picks, the process is mostly automated. You're essentially building wealth without even thinking about it. Plus, you might get some free employer match contributions to speed up your progress.
But even with those perks, you'll want to stash some cash for retirement outside of your 401(k), too. You'll agree once you take a look at these four drawbacks of relying solely on your 401(k) for retirement.
1. No tax diversification
The distributions you take from your 401(k) in retirement are taxed as regular income. This is how you repay the government for the tax deductions you received on your contributions and the tax deferrals on your earnings. It's a reasonable trade-off, as long as you expect to be in a lower income tax bracket after you leave the workforce.
The trouble is, when you're in your 30s or 40s, you likely don't know what your tax situation will be in retirement. You could make less as a retiree, but who knows? If you are a disciplined saver, you might make more. It's also impossible to predict the future of income taxes in the U.S. Some financial gurus argue that everyone will be paying higher taxes in the future, given that the government has recently spent trillions on COVID-19 relief.
You can address that uncertainty by saving to a Roth IRA alongside your 401(k). Roth IRA contributions are not tax deductible in the current year, but your distributions in retirement are tax-free. Alternatively, if your 401(k) offers a Roth 401(k) option, you could use that as well.
2. You can't retire too early
Normally, you can't start taking 401(k) distributions without tax penalties until the age of 59 and a half. The usual 10% penalty is waived, however, for distributions if you leave your job for any reason in the year you turn 55 or later, or 50 for public safety workers. Note that the waiver only applies to the 401(k) managed by your most recent employer. If you've saved enough in that account, you do have some freedom to retire in your 50s -- but not before.
To improve your early retirement options, diversify outside the 401(k) and save to either a Roth IRA or a taxable brokerage account. A Roth IRA has the advantage of tax-deferred earnings and, as noted, tax-free distributions in retirement. But you can also withdraw your contributions from your Roth IRA, without taxes or penalties, at any time. Just keep good records so you don't accidentally withdraw any earnings on your contributions. The earnings have to stay in the account until you're 59 and a half.
A taxable brokerage account has no restrictions on withdrawals, but you get no tax benefits, either. That means you'll pay taxes every year on your interest, dividends, and realized gains in that account. You can manage that tax bill somewhat by investing in growth stocks that you can buy and hold for long periods of time. As long as you're not earning dividends or realizing gains, your account won't generate much in the way of taxable income.
3. You have limited investment options
Your 401(k) offers a handpicked selection of funds -- which could be very limiting. Some plans do offer what's called a brokerage window, which gives you a broader selection of securities to buy. But if you don't have a brokerage window, you may want to invest a portion of your wealth elsewhere. You can use a traditional IRA, Roth IRA, or taxable brokerage account to house securities you can't get in your 401(k).
4. You might pay more in fees
Fees are perhaps the greatest drawback of the 401(k). Your plan administrator might be siphoning off 1% or 2% of your wealth to cover the plan's operating costs. On top of that, you'll pay for the normal operating expenses charged by your mutual funds. The percentages for those fees can be small -- less than 0.50% -- but they still take a piece of your earnings over time.
Cumulative fees of, say, 2% are significant when you consider that the stock market's average annual return is about 7%. If your investments are tracking with the market and then you absorb 2% in fees, your net return is only 5%.
The solution here is to invest in stocks, which have no fees, outside of your 401(k) in a low-cost brokerage or IRA account. Or, if you don't want the job of diversifying and managing a stock portfolio, choose low-cost index funds. Fidelity 500 Index Fund (FXAIX 0.01%) is an example; its expense ratio is 0.015%.
Diversify your savings
It's smart to use the automation features of your 401(k) to put your retirement savings on autopilot. But take the extra step of saving elsewhere, too. For most savers, a Roth IRA or a taxable brokerage account is an ideal complement to the 401(k). You get tax diversity plus greater freedom to design a retirement portfolio that suits your needs. And, to the extent you are successful investing outside your 401(k), early retirement could be well within your grasp.