401(k)s are among the most popular retirement savings vehicles for plenty of reasons. They offer high contribution limits, and employers can match some of their employees’ contributions. Plus, the money comes right out of your paycheck every month, so you don’t have to remember to make contributions manually.
But 401(k)s also have their drawbacks, and if one of these accounts is your only home for your retirement savings, you could be making your job more difficult than it has to be. Here’s a closer look at three pitfalls of relying exclusively upon your 401(k) for retirement savings.
1. Your investment options are limited
Most 401(k)s only offer a handful of investment options preselected by your employer. It’s possible there’s something in there that suits you well, but this isn’t always the case. If you end up with investments that are too aggressive for your risk tolerance, you put yourself at risk of significant losses if the markets take a downturn. And if you invest too conservatively, you might not earn as large a return as you could have if you had your money invested in something more appropriate to your situation.
401(k)s are also known for having higher administrative fees than some other types of retirement plans, like IRAs. Investments have their own fees as well, like the expense ratios on mutual funds. If your 401(k) only offers high-cost investment options, these fees will eat into your profits over time, forcing you to set aside even more money of your own to afford your retirement.
If you’re not happy with your 401(k)’s investment options, talk to your employer and see if it is willing to offer more low-cost options, like index funds. You can always keep some of your savings in an IRA, which gives you a lot more freedom to invest your funds how you’d like, if your company doesn’t comply.
2. You might be limited to tax-deferred savings only
Traditional 401(k)s, which are the most popular, are tax-deferred. This means your contributions lower your taxable income this year, and you pay taxes on your distributions in retirement. But Roth 401(k)s are becoming a popular alternative because they enable people to pay taxes on their contributions now in exchange for tax-free withdrawals of contributions and earnings in retirement.
Not all plans offer a Roth 401(k) option, though, so if you’re only using a 401(k), you could be stuck with tax-deferred savings, even if that’s not what’s best for you over the long term. Tax-deferred retirement accounts are a good fit for those who expect their income to drop significantly when they enter retirement. By delaying taxes until later when their income is lower, they may lose a smaller percentage of their savings to the government.
But Roth accounts are better if you think you’re earning about the same or less than you will spend annually in retirement. Paying taxes on your contributions now will save you money compared to paying taxes on larger distributions in retirement.
If you think Roth savings would be a better fit for you and your company doesn’t offer a Roth 401(k), consider putting money into your tax-deferred 401(k) first to get any employer match your company offers. After that, switch to contributing to a Roth IRA until you’ve contributed up to the maximum — $6,000 in 2020 or $7,000 if 50+ — and then switch back to your 401(k) if you’d still like to contribute more.
3. You can’t make lump-sum contributions
Employers usually only allow you to contribute money to your 401(k) via paycheck deferral, and that’s fine for most people. But if you end up with some extra money in your bank account that you don’t need, you can’t just write a check and add that to your 401(k) like you could to an IRA.
There’s a convoluted way around it. You could temporarily raise the percentage of each paycheck you put toward your 401(k), use the extra money in your bank account to cover your living expenses, and then revert to your old paycheck deferral percentage once you’re done contributing the extra funds. But that’s a lot more complicated than just opening an IRA and putting your extra money there instead.
A 401(k) can be a great place for your retirement savings, but as with any retirement account, it’s important to understand its limitations and make up for its drawbacks if you can. Supplementing your 401(k) with an IRA can give you more freedom to contribute money whenever you want, and to choose how that money is invested and when it’s taxed.