3 Drawbacks of Using Only a 401(k) for Retirement

If you have a 401(k) at work and your employer offers you a match, you should contribute enough to your account to earn the full match. HR or your plan administrator can explain how the match works, how much you must contribute to max it out, and how to sign up to have 401(k) contributions withdrawn from your checks.

Once you have maxed out your employer match, though, you may decide you want to put some of your money into other tax-advantaged retirement accounts. For example, you may decide you want to open a traditional IRA with a brokerage firm. Or you may opt for a Roth IRA.

Here are three big drawbacks to using only a 401(k) for retirement that could make investing some money in these other accounts attractive.

1. Your 401(k) may have limited investment choices

Your employer sets up your 401(k), and you have to deposit your funds with the plan administrator your company has chosen. Once your money is in your 401(k), you have to pick from the investment choices your plan makes available. Sadly, you probably are not going to have a big selection.

Typically, 401(k) options include target date funds that adjust where your money is invested based on how far you are from retirement, or other mutual funds that give you exposure to specific kinds of investments such as large or small companies. The Investment Company Institute found that in 2021, typical 401(k) plans offered an average of 13 different equity fund options for investors.

Being able to choose from only a small number of funds to invest in is a big downside of using only a 401(k) to save for retirement. If you were instead to open a traditional or Roth IRA with a brokerage firm or another financial institution, you could access virtually all the assets that institution allows you to trade. This could include thousands of ETFs, mutual funds, and bonds, not to mention shares of any publicly traded company.

If you want to develop an investment strategy that goes beyond the limited funds your 401(k) offers, you won't want to stick with just 401(k) investing alone. Instead, you could research brokerage firms that have good screening tools to help you pick investments and then open up a traditional or Roth IRA with one of them.

2. Distributions could make Social Security taxable

When you put money into a 401(k), your withdrawals in retirement are going to be taxed at your ordinary income tax rate. Many people know that. What you may not know, though, is how the withdrawals could impact the taxation of your Social Security benefits.

Your Social Security benefits are not subject to tax as long as your countable income is below $25,000 for single tax filers or $32,000 for married joint filers. Once that threshold is reached, up to 85% of benefits can become taxable depending on how high your income actually is. Countable income isn't all your income -- it's half your Social Security benefits, all taxable income, and some non-taxable income (like MUNI bond interest).

All of your 401(k) distributions count in determining if you hit the threshold when Social Security becomes taxable. But if you were to put some of your retirement money into a Roth IRA, withdrawals from that account aren't part of your countable income. So this could help you stay below the threshold you need to in order to avoid owing taxes on Social Security.

3. You could have trouble with early retirement

The general rule is that you cannot take money out of a 401(k) until age 59½. While there are some limited exceptions, you'll typically face a 10% penalty if you withdraw money from your account before then.

If you're eager to retire really early -- like in your 50s -- you're going to need to put some retirement money into a taxable brokerage account you can access when you want without taking that penalty hit.

For all of these reasons, you may want to think seriously about whether using only a 401(k) for retirement is the right choice or whether there are other accounts -- like a Roth IRA or taxable brokerage account -- you should also consider to help you save for your future. If you want more investment options, less chance of Social Security tax, and easier access to your money for early retirement, you may decide it makes sense to open a different kind of retirement account today.