Here’s Why a 401(k) Alone Is Not Enough for Retirement Savings

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Retirement planning can be complicated and stressful. For that reason, many people simply opt to fund their employer-provided 401(k) up to the maximum limit and trust that they’ll have enough for retirement. 401(k) plans are a solid way to save for retirement because you make contributions on a pre-tax basis and pay no taxes on your earnings until you withdraw them. Furthermore, many employers match employees’ contributions, at least up to a certain percentage. However, caps on contributions limit the 401(k)’s ability to provide a comfortable retirement on its own. In addition, a 401(k) comes with many restrictions on how you can withdraw the money, and accessing it in other ways can result in hefty penalties that significantly cut into your savings.

Ultimately, you should at least consider other ways of saving for retirement to supplement your investments, especially once you’ve maxed out contributions to a 401(k). These alternative forms of saving could be anything from Roth accounts to annuities, which provide steady, predictable income throughout retirement.

To understand why a 401(k) alone is typically not sufficient for retirement savings, consider the following points:

1. 401(k)s have little liquidity.

Once you put money into a 401(k), it is essentially locked in a safe that stays closed until you reach retirement. This illiquidity is by design. The rules governing 401(k)s are meant to discourage people from touching the money until they retire. Tapping into the money early results in a variety of penalties and taxes, unless a few specific circumstances apply. Ultimately, a 401(k) is not an emergency fund nor a short-term savings account. The penalties and taxes help ensure that you do not waste your savings before retirement, but they also keep you from your money, even when you truly need it.

For these reasons, you should have other savings accounts without the same stiff penalties on withdrawals, so you can rely on them in a financial emergency. Otherwise, you may find yourself paying a 10-percent penalty on top of normal taxes, just to make ends meet.

2. 401(k)s involve hefty fees.

401(k) fees are often overlooked. The administrative fees of a 401(k) can add up quickly, and the typical account can have as many as a dozen undisclosed fees. These costs include bookkeeping, finder’s, trustee, and legal fees. It may be difficult to determine whether you’re being taken advantage of with these fees, so be sure to pay close attention and read the fine print when choosing the best vehicles for savings.

In fact, 401(k) fees can reduce your savings by up to half. That’s because even a small fee can result in significant losses when you consider how much it would generate in compound interest over time if the money remained in your account.

This is not to suggest that 401(k)s are useless. If you completely avoid 401(k)s, you’re giving up significant tax benefits-and essentially free money if your employer matches your contribution. A better plan is to diversify your portfolio with a 401(k) and other investments that do not have such hefty fees.

3. 401(k)s have limited options.

One of the biggest issues with a 401(k) is the limited range of investment options. In general, these accounts grant access to a few index or target date funds, but do not allow account holders to invest in individual stocks. In addition there is very often a lot of redundancy in the mutual fund choices the participant is given, In other words, there may be several large cap US funds, and a couple of mid cap or small cap fund choices, but no natural resources, or real estate, or precious metals, or foreign bonds, all of which would help in the pursuit of diversification and a smoother long term ride. As a result, people who depend solely on a 401(k) cannot achieve much diversification in their investments. To avoid this issue, you can turn to other options.

If you don’t want to invest directly because of the lack of tax benefit, you might consider an individual retirement account (IRA). Typically, IRAs offer many more investment options than 401(k)s because they are offered through brokerages. With an IRA, you can usually purchase any asset offered by the brokerage. Some IRAs even allow you to invest in nontraditional assets like bitcoin and gold. These investments have greater risk, but also a chance for greater returns.

4. 401(k)s can increase your taxes.

People often forget about taxes during retirement, but that’s a big mistake. During retirement, distributions from a 401(k) are taxed at ordinary income rates. In contrast, distributions from Roth accounts are not taxed at all-contributions to these accounts are taxed at the time you make them. If you only have access to a 401(k), you will ultimately pay more taxes than you would if you also had access to a Roth 401k account. If you accumulate a lot of money in the tax deferred 401k or 403B, you’ll be pushed into a higher tax bracket if that is your only source of income besides your Social Security, and the fully taxable 401k distributions could in fac, make your Social Security taxable or taxable at a higher than necessary rate.

With a Roth account, you can avoid being pushed into that higher tax bracket, which can ultimately save you considerable money during your retirement. You should also think about the fact that Social Security benefits become taxable once you reach a certain income level. 401(k) distributions are considered in this income, but distributions from Roth accounts are not, so doing a series of ROTH conversions is another way a Roth account can help you save on taxes in retirement.

Originally published at on October 19, 2020.

Robert Ryerson authored the 2016 book What’s the Deal With Identity Theft?: A Plain English Look at Our Fastest Growing Crime.

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