Three Cons of (Entirely) Relying on a 401(k) for Retirement

For most people, a 401(k) is an excellent way to save for retirement. Because your employer maintains it, it's incredibly simple to utilize. In addition, it comes with significant tax benefits. Your employer may even offer you free money to put into it if your business matches 401(k) contributions.

If your company matches your contributions, you should always try to contribute enough to reach the maximum before using any retirement funds. After all, passing up free money isn't always the wisest financial decision.

However, after you've achieved that company match, there are several compelling reasons to explore other retirement options. There are three major disadvantages to relying only on a 401(k).

Here's a list of them.

 

1. There's a chance you'll be hit with hidden fees.

Fees are never good for investors since they cut into their profits. However, for retirement investors who leave their money in a 401(k) plan for decades, fees may be huge since they drain money from your account year by year.

The good news is that the majority of 401(k) account fees are relatively inexpensive. According to Employee Fiduciary's analysis, the average all-in fee in 2021 was 1.18%. The bad news is that they discovered "hidden" administrative fees in nearly 76% of 401(k) plans.

Always review the 408(b)(2) fee disclosures provided by your plan to find out the facts about what you're paying. You may discover that the fees are more significant than you’re willing to pay, which is a significant disadvantage of using a 401(k) as your primary retirement plan.

That’s especially true now that an increasing number of brokers are attempting to remove commissions and other fees, which may make investing in an IRA through a cheap broker much more affordable.

2. You might wind up with a bigger tax bill.

If you only have access to a standard 401(k) and not a Roth IRA, keeping that 401(k) as your only retirement account would mean contributing all of your pre-tax funds. That seems nice until you remember that, as a retiree, any disbursements from that account will be taxed income.

An upfront tax deduction may seem like a better deal if you believe you'll be in a lower tax bracket when you retire than when you're working. However, remember that tax rates are at a record low right now, and the government has been spending a lot for quite a long time without raising taxes.

It’s unavoidable that the interest rates rise at some point to deal with the growing deficit and debt. But, unfortunately, that might happen before you retire, so your rate may wind up greater than expected.

You should also remember that if your "provisional" income hits a particular level (which isn't adjusted for inflation, so it goes smaller in real terms every year), your Social Security payments will become taxable. Traditional 401(k) payouts are included in this income computation, while Roth account payouts aren’t.

When you consider the big picture, you might decide that investing part of your retirement funds in a Roth IRA is a better option than relying entirely on your 401(k).

3. You might be limiting your investment returns.

A 401(k) allows most people to choose their investments from a modest pool of assets. These are probably index funds.

As index funds invest in a small portion of many different assets, it's not likely that they will outperform the market by a significant margin. Although these investments are less risky than alternatives, like individual stocks or cryptocurrencies, they also limit prospective profits because the many companies that comprise the index must exceed the market by a large margin.

You won't be able to put all of your retirement earnings into a 401(k) if you wish to choose retirement investments from a larger pool of possible assets. But, of course, before taking on further risks, you must be sure that you have a strong investment thesis and that you will not jeopardize your future financial stability.