Investing in a 401(k) plan is amongst the simplest ways to save for retirement. Once you decide on the amount of contributions to be making monthly, the amount is automatically deducted from your paycheck each month. You are building wealth without having to second guess or overthink it. There’s also the benefit of an employer’s match, which can help speed up your progress.
Despite its advantages, it’s advisable to have a stash of your retirement savings outside a 401(k). Here are four setbacks of investing solely in a 401(k) plan.
1. No Tax Diversification
401(k) distributions in retirement are taxed like regular income. That’s how the IRS takes back the tax deductions you received on contributions to the plan and the tax-deferral on your earnings. It’s a beneficial trade-off provided you remain in the same income bracket you are now when you leave the workforce.
The fact is that you can’t predict what your income and, subsequently, your tax situation will be in the future. You can earn less, or you can earn higher, which can increase your income bracket.
Similarly, one can’t predict what the future holds for U.S income taxes. Most experts have argued that taxes will mostly be increased considering that the government has spent trillions on coronavirus relief.
To address the uncertainty, it’s advisable to invest in a Roth IRA alongside your 401(k). Contributions to Roth IRAs are not tax-deductible, but in turn, you’ll enjoy tax-free distributions in retirement.
2. It’s Never Too Early To Retire
Withdrawals from a 401(k) account attract a 10% penalty if you are not up to 59½ years old. This penalty is waived if you happen to leave your job in the year you hit 55 or older (50 for public safety workers). It’s important to note that said waiver will only apply to your 401(k) balance with your most recent employer. So if you have enough funds in that account, you can retire in your 50s.
If you plan to retire early, diversifying your retirement savings to Roth IRAs or taxable brokerage accounts will increase your options. Contributions to Roth IRAs are not tax-deductible so that you can withdraw your contributions from the account without any tax or penalties. Just ensure you don’t withdraw the earnings on your contributions. You can only withdraw your earnings when you are 59½ years old.
On the other hand, a taxable brokerage has no restrictions on withdrawals, but it also has no tax benefits. So contributions are not tax-deductible, and you’ll pay taxes yearly on your interest, dividends, and gains to the account.
You can lower the tax burden by buying and holding growth stocks. Provided you are not realizing any profit or earning dividends, your taxable income won’t rise high.
3. Your Investment Options Are Limited
401(k) plans typically offer a selected group of funds, which could limit your investment options. Some plans offer a brokerage window that provides a broader selection of securities to invest into. But if your plan doesn’t have a brokerage window, then consider putting part of your savings into Roth IRAs, traditional IRAs, or taxable brokerages. These investment options will allow you to get what’s unobtainable with your 401(k).
4. You Could End Up Paying More in Fees
One of the drawbacks of 401(k) accounts is that the plan administrator can charge as much as 1% or 2% as operating fees for the plan. In addition to that, you’ll still pay the operating expenses mutual funds charge. While these percentages look smaller, they can still eat into your earnings over time.
If you consider the typical stock market annual return of 7%, you’ll realize that a 2% cumulative yearly fee is over the edge. If your investment charges you 2%, you’ll be left with 5%.
The solution available to you is to invest in stocks in a low-cost brokerage or IRA account outside your 401(k) plan. Alternatively, you can invest in low-cost index funds like the Fidelity 500 Index Fund (NASDAQMUTFUND: FXAIX).
Diversifying Your Savings
While using automation to contribute to your 401(k), it’s also essential to take extra steps to save elsewhere. For most retirement savers, investing in Roth IRA or brokerages complements their 401(k).
The benefit is that you get tax diversification and greater freedom to retire earlier than normal.