Insights

3 Plain-as-Day Reasons Your 401(k) Can Be Overrated

Any time you’re saving and investing for retirement, it’s a good thing. A 401(k) plan is the most popular type of retirement account, and it comes with great benefits — such as pre-tax contributions — that you should absolutely take advantage of. As with most things, though, there are pros and cons to a 401(k) plan. The benefits of a 401(k) far outweigh the drawbacks, but they’re drawbacks nonetheless.

To put yourself in the best position to accomplish your financial goals for retirement, you need to be multifaceted and use all available resources, including various other retirement accounts that make up in places where a 401(k) may lack.

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1. Your investment options are limited

You can’t just make any investment you want in a 401(k) plan. Your plan provider gives you options to choose from, and unfortunately, this means it can be limiting. With a 401(k), you can bank on your options consisting of your company’s stock (if it’s a public company), market cap-based funds, and target-date funds that reallocate as you near retirement. These aren’t bad investment options by any means, but there are tons of other great investments out there that you won’t be able to access in your 401(k).

Retirement accounts like Roth IRAs and traditional IRAs essentially work like brokerage companies, so you can invest in any company or index fund you want. Whether you want to invest in your favorite tech company, one of the major indexes, or industry-specific index funds, you can do so in an IRA account. Having these options gives you more control over where your money is going and ensures that it aligns with your investment strategy.

2. The fees can be expensive

One of the downsides of a 401(k) plan is that it can be expensive. Not only do you pay management fees charged by your plan provider, but you’ll also have to pay the fees that come along with the specific investments you hold in your account, as well as fees that may come along with different services you elect into. Even a fee of 1% may seem small, but over time, it can add up to thousands of dollars. If you have $100,000 in your 401(k), a 1% fee means you’ll be paying $1,000 annually; if your account gets to $1 million, you’ll be paying $10,000.

Investment options in your 401(k), like target-date funds, can also eat away at your returns (or add to losses). Since target-date funds are actively managed, their fees are much more expensive than passive index funds. For investors who want to take a set-it-and-forget-it approach, target-date funds can be useful because they do a lot of the heavy lifting for you, but they don’t come without a price.

3. You’ll eventually have to take required minimum distributions

You can begin taking distributions from your 401(k) plan at age 59 1/2 without having to pay a 10% early withdrawal penalty, but it’s not mandatory. However, once you reach age 72, you’re required to begin taking distributions. Required minimum distributions are mainly to prevent people from using their 401(k) plan as a means to avoid paying taxes. There’s one thing you can count on with Uncle Sam: He’s going to want his money eventually.

Since you receive your tax break on the front end with a 401(k) — by way of pre-tax contributions — you must pay taxes on that amount on the back end. This isn’t the case with a Roth IRA, however. Since you contribute after-tax money into a Roth IRA, you get to take tax-free withdrawals in retirement. This means your money gets to grow and compound, and you don’t have to worry about capital gains taxes on the profits you make along the way.

The Motley Fool has a disclosure policy.

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