401(k)s aren’t all created equal, and using a bad one to save for your retirement could make your job a lot more difficult. Different types of retirement accounts have different strengths and weaknesses, so it helps to have more than one. Here’s a closer look at some of the ways you might be shortchanging yourself if you’re only using a 401(k).
1. You probably won’t have as many investment options
A 401(k) usually lets you choose from a handful of mutual funds your employer selected, and sometimes that’s fine. But if there aren’t any options that appeal to you, there isn’t a lot you can do. Your employer might be willing to add some more investment choices if you request it, but it doesn’t have to.
Without another retirement account, you could be stuck with investments that don’t suit your risk tolerance or don’t have a great rate of return. At best, that could force you to wait longer to retire, and at worst, it could threaten your financial security in your senior years.
If you don’t love your investment choices, consider opening an IRA and putting some of your retirement savings there instead. IRAs enable you to invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs), and a bunch of other things. This gives you more control over your portfolio, and you could earn more over time if you choose the right investments.
Just remember you’re only allowed to contribute up to $6,000 to an IRA annually in 2020 and 2021 or $7,000 if you’re 50 or older. So if you start saving in one of these accounts, you might have to switch back to your 401(k) after you’ve hit the contribution limit.
2. You could pay higher fees
Another downside of limited investment options is that there’s less you can do to reduce your fees. It’s always good practice with any retirement account to understand what you’re paying annually and to check periodically to see if there are more-affordable investments that would suit you. You can do this by looking at your plan summary or your prospectus. But if your company doesn’t offer many other investment options, you may be stuck paying whatever fees you have now.
Fees cut into your profits, forcing you to save for longer before you can afford to retire. While every plan is different, many 401(k)s charge higher fees than IRAs, so stashing some money in an IRA and choosing low-cost investments, like index funds, could help you grow your wealth more quickly than just using your 401(k).
Of course, you have to weigh the value of any employer 401(k) match you’re receiving. That’s something you can’t get with an IRA, so if your company’s match covers what you’re paying in fees, it’s worth contributing at least enough to get that match every year. Then you can switch to an IRA if you’d like to save even more.
3. You might end up paying more in taxes
Most 401(k)s are tax-deferred, which means your contributions reduce your taxable income this year, and then you pay taxes on your distributions later. These accounts are a good fit for those who think they’re earning more money now than they will spend annually in retirement. By delaying taxes until retirement, when you’ll hopefully be in a lower tax bracket, you’ll pay the government a smaller percentage of your savings.
But if you think you’re earning about the same or less than you’ll spend in retirement, a traditional 401(k) could just end up costing you more. You’re better off saving in a Roth 401(k) if your company offers one of these. They work the opposite way: You pay taxes on your contributions this year so you can enjoy tax-free withdrawals in retirement.
While Roth 401(k)s are becoming more common, not all companies offer them. If yours doesn’t, consider a Roth IRA instead. The government taxes these the same way as Roth 401(k)s, though you may only contribute up to $6,000 per year or $7,000 if you’re 50 or older. Should you exceed this, you can always return to your regular 401(k). It may not provide the best tax advantages for you, but it’s still something.
My goal here isn’t to scare you off 401(k)s but to help you understand whether a 401(k) is the best place for your savings. If you haven’t thought about how your income today compares to your projected income in retirement, or you haven’t reviewed your investment options and their associated fees within the last year or so, do so now. If you’re happy with your 401(k), that’s great, but if not, consider stashing some of your savings in another account, like an IRA, to make up for some of your 401(k)’s shortcomings.