A 401(k) can be an excellent tool to save for retirement, which is why the 401(k) is the retirement account of choice for so many employers. In a traditional 401(k), the money you set aside reduces your taxable income and is then allowed to grow tax-deferred until you retire. However, there are some negative features of 401(k)s that you should know about. Here are three of them, as our contributors explain.
One surprising disadvantage of 401(k) accounts, especially when compared with other retirement accounts such as IRAs, is the inability to withdraw your money early in certain situations.
Specifically, you are allowed to withdraw up to $10,000 from your IRA to use toward a first-time home purchase, either for yourself or as a gift. And you can withdraw any amount from an IRA penalty-free to cover higher-education expenses for you, your children, or your grandchildren. Try doing either of those things in your 401(k), and you'll be subject to a 10% penalty. Many people are under the impression that they'll just tap into their 401(k) when these situations arise, but it's actually not an allowable reason to use your money early.
There are a few acceptable reasons the IRS will allow you to dip into your 401(k) penalty-free, such as to pay medical bills that exceed 10% of your income, or if you become separated from your job after age 55, but the reality is that IRAs can be more flexible when it comes to early withdrawals.
It's also worth mentioning that 401(k)s allow participants to borrow money from their accounts if their plan allows for it, but know that if you do this, you'll have to pay yourself back with interest.
One of the great things about 401(k)s is tax-free growth. However, they may not be as tax-efficient when you take distributions in retirement, especially if you've built up a significant portfolio of dividend-paying stocks and you plan to live on those dividends.
The give and take of 401(k) investing means you're able to deduct current contributions from your income, so you pay fewer taxes now while also growing your nest egg tax-free, but the exchange is paying regular income taxes on distributions in retirement.
This method differs from the way long-term capital gains are taxed in your taxable investing accounts -- at 15% for most people and 20% for those with higher incomes. Currently, regular dividends are taxed as long-term capital gains.
For retirees earning more than about $85,000 in taxable income this year, the effective income-tax rate they will pay would be higher than the 15% capital-gains rate. Considering that any income for joint filers making more than $74,900 is taxed at 25%, the math gets worse the higher the income goes.
It's not fair to say that this is a raw deal, considering the years of tax-free growth and the up-front tax savings, but it's something higher-income retirees should be aware of. The good news is that most retirees will fall into the tax bracket below this level and pay a lower federal rate than 15%.
One problem with many 401(k) plans is high fees. Making matters worse, few people are even aware that their 401(k) plans charge any fees. (As you can imagine, that doesn't serve to keep fees low.) A 2011 AARP survey found that 71% of respondents believed there were no fees!
Fees exist, though, and they can be substantial. A 2014 report by Deloitte found that the median 401(k) fees ranged from 0.37% for large plans (those managing more than $500 million) to 1.27% for small ones (with assets of $1 million to $10 million). Some employers will pay some of those fees, but plenty do not. The 0.37% fee isn't troubling, but that 1.27% certainly is -- and remember, that's just a median number, meaning that many retirement savers pay much more. A 2012 report by think tank Demos noted that such fees can amount to more than $150,000 in lost savings for a median-income two-earner family -- nearly a third of their investment returns!
Here's an example. Imagine that your household manages to sock away $10,000 per year in 401(k) plans, earns an annual average return of 8% over 25 years, and pays an average of 1.5% in annual fees. The total end result? A $627,000 nest egg. Impressive, eh?
Well, that's based on an annual growth rate of 6.5%, because 1.5% was subtracted from the pre-fee 8% return. What if the fees were 0.5% -- just 1 percentage point lower? If your investments grew by 7.5% annually, they'd total more than $730,000. That's a difference of nearly $100,000. When you're living off your nest egg in retirement, you will certainly miss the gains you sacrificed to fees.
What can you do? Start by contacting your plan administrator and asking for a detailed listing of all fees you're charged. If you don't like what you see, lobby for changes to be made. There are inexpensive plans and funds out there.