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401(k)s are widely considered to be one of the best retirement savings accounts for a lot of good reasons. They have high contribution limits, you can automate your contributions, and if you’re lucky, your employer will chip in too. But despite all of its advantages, a 401(k) isn’t always the best place to stash your retirement savings. Weigh the following three drawbacks before deciding if it’s the best home for your money.
1. Limited investment options
When you invest in a 401(k), you’re usually limited to target date funds and other mutual funds your employer selects. For some people, this is fine, but if you’re hoping to invest in individual stocks, for example, a 401(k) will feel too restrictive for you.
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In that case, you have two options. If you don’t like the investment options your 401(k) offers, you can talk to your employer about adding more. But if you’re hoping that results in free rein to invest in anything you want, that’s probably not going to happen.
You could also invest your money in an IRA instead. This gives you a lot more freedom to put your money to work the way you want. However, the IRA is not as generous as the 401(k) with its annual contribution limits. You can only contribute $6,000 to an IRA in 2021, or $7,000 if you are 50 years or older. That compares to $19,500 for a 401(k), or $26,000 if you’re at least 50. If your retirement contributions exceed the annual IRA limit, you could always switch back to your 401(k) after you’ve maxed out your IRA.
2. High fees
With few investment choices, you’re also restricted in what you can do to minimize your fees. If all the mutual funds available to you have high expense ratios (1% of your assets or more), you would be giving up at least $1 of every $100 you have invested each year. That can significantly slow the growth of your nest egg, and you may have to contribute more money yourself each month to reach your retirement goal.
You’ll also have administrative fees. These are fees related to record-keeping and providing employees with online access to their accounts, among other things. There isn’t much you can do about these expenses, and they can be costly, particularly at smaller companies where there are fewer employees to help shoulder the burden.
Check with your employer or your 401(k) plan administrator if you’re unsure how much you’re paying in fees. You may be able to bring your costs down slightly by changing what you invest your money in. But if you’re still not happy with how much you’re paying, you can always save money in your IRA first. They tend to have lower administrative costs, and with a larger selection of investments, you have more low-cost options such as index funds.
3. No say on taxes
Most 401(k)s are tax-deferred, which means your contributions reduce your taxable income upfront, but you pay taxes on your withdrawals. This might be fine if you think you’re in a higher tax bracket now than you will be once you retire. But if not, you may prefer to save for retirement in a Roth account.
Roth accounts don’t give you any tax breaks initially, but your withdrawals are tax-free in retirement. They’re usually the smarter choice for those who think they’re in the same or a lower tax bracket now than they will be once they retire.
An increasing number of employers are now offering Roth 401(k)s, which are just like regular 401(k)s except you pay your taxes upfront rather than in retirement. This is worth considering if your company offers one, but if not, you can always stash your money in a Roth IRA first. Then, if you hit the annual IRA contribution limit, you can switch back to your 401(k).
Focus on what’s best for you right now
Understanding your 401(k)’s strengths and weaknesses is key to deciding whether it’s the best place to put your money. If your company matches your contributions, you should contribute enough to it get the full match. But if you then decide an IRA has more appeal, you can focus your contributions there instead.
The right account for your money could change over time, so don’t feel like you have to decide now what’s best for the rest of your life. Consider your current situation, and reevaluate your decision every year or two to make sure you’re still where you want to be.
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