6 Disadvantages of Saving With a 401(k) Plan

According to the latest data from the U.S. Census Bureau, 34% of working Americans aged 15-64 have a 401(k) plan.. If you’re already enrolled or considering signing up, you may view it as a straightforward perk, like health insurance or paid time off. But while a 401(k) offers tax advantages and employer contributions, it also comes with limitations. Before committing to or relying solely on this retirement savings method, consider these six key disadvantages.

A financial advisor can help you understand if a 401(k) is the right fit for your broader financial strategy

401(k) Disadvantage #1: You Could End Up Paying More in Taxes

The big appeal of 401(k) plans is that they act as tax shelters. As long as you leave the money untouched, you don’t owe taxes on the funds you contribute to the plan, and you don’t owe taxes on any gains.

Yet you will have to pay taxes once you retire and start making withdrawals from your account. You’ll owe income tax on your contributions and on your gains. So if you have a bigger income when you retire than when you made contributions, you’ll be in a higher tax bracket and owe more than if you hadn’t deferred your taxes. Similarly, if your tax bracket puts you at a higher rate than the long-term capital gains tax rate, you will pay more in taxes.

That said, most people expect to earn less when they stop working since their only income will be from their investments and Social Security. But those just starting in their careers are, indeed, likely making less now. Alternately, people who have been smart about saving and investing may have a higher income when they retire.

If you’re an entry-level or a superstar saver, you may want to consider a Roth IRA or see if your company offers a Roth 401(k). With these savings plans, you pay income taxes upfront on your contributions and no taxes on any gains when you retire.

401(k) Disadvantage #2: Contributions Follow a Schedule, Regardless of Market Conditions

Of course, you should never try to time the market. Experts base this advice on something called dollar-cost averaging. The idea is that if you steadily buy small amounts during market highs, lows and plateaus, you will ultimately pay less for all of your investments than if you tried to buy only at the lows. This is partly based on the fact that you don’t know a bottom until it has passed. Plus, most people don’t have time to watch the market – or the discipline to set aside money for later purchases.

Yet in real-time, you may want to hold off a purchase by even a day or increase the amount during a sell-off. Neither is possible with a 401(k) since purchases follow a regular schedule and changes take time to process. Also, many plans limit the number of times you can make adjustments to your plan.

If you don’t pay attention to the markets, the lack of flexibility doesn’t apply to you. However, if you’re a DIY investor, you may want to contribute to your 401(k) only up to your company match and then put the rest of your savings in an individual retirement account (IRA) that you can control.

401(k) Disadvantage #3:You May Be Paying More in Fees

Employer-sponsored retirement plans are heavily regulated. That’s a good thing. Your company can’t put vesting requirements on your withheld wages, for example. But it also means that the administration of your plan comes with high fees. They’re often baked into mutual fund expenses, but you may also see them as separate charges and itemized costs for administrative services.

Ideally, your employer did due diligence when choosing a plan administrator. That said, smaller companies may pay higher fees since the economies of scale aren’t in their favor. If you think your plan is too expensive, again, you may want to contribute to it only up to your company 401(k) match and then put the rest of your retirement savings in an individual account that you can choose.

401(k) Disadvantage #4: Your Investment Choices Are Limited

Hopefully, your plan offers a variety of options: index and actively managed funds; large- mid- and small-caps; growth, value and conservative funds; company stock and more. But the number and kind of offerings are up to your company.

If you are an experienced and successful investor and you don’t like your company’s options, you may want to go the IRA route, after getting the company match. After all, the smart money wouldn’t leave free cash on the table. And if you’re seeking outside help as you make your investment decisions, make sure you’re examining these must-do moves before choosing a wealth management firm.

Calculate whether your own investment choices currently have you on pace to retire with what you need:

401(k) Disadvantage #5: You Can’t Easily Touch the Money Before You Retire

Of course, you shouldn’t touch the money before you retire. If you make a withdrawal before age 59.5, you’ll pay a high-to-be-prohibitive 10% penalty, plus taxes.

But desperate situations call for extreme measures. Huge medical bills are an example. The IRS allows for penalty-free hardship withdrawals but employers don’t have to provide for them. Many will offer the option of a loan (you have to pay yourself back) rather than a withdrawal.

An emergency savings fund is the best way to prepare for unexpected expenses. Still, if having the option of tapping retirement savings is important to you, a 401(k) may not be as well-suited for your needs as a Roth IRA. With a Roth IRA, you can withdraw your contributions (but not your earnings), penalty-free and at any age.

401(k) Disadvantage #6: Required Minimum Distributions Can Reduce Control Over Income

Traditional 401(k) plans are subject to required minimum distributions (RMDs), which generally begin at age 73 (or age 75 if you were born in 1960 or later). Once these rules apply, you must withdraw a minimum amount each year, even if you do not need the income.

These required withdrawals can increase taxable income in retirement and may affect other costs tied to income levels, such as Medicare premiums. Because RMD amounts are based on account balances, strong market performance can also result in larger mandatory withdrawals than expected.

Unlike Roth IRAs, which do not require distributions during the original owner’s lifetime, traditional 401(k) plans limit how long assets can remain invested on a tax-deferred basis. This can reduce flexibility in managing income and taxes later in retirement.

Bottom Line

For most people, a 401(k) plan is a great work benefit. This is particularly the case if their company matches some part of their contribution. But for other people, especially those who are early in their careers or are experienced, hands-on investors, other savings vehicles that don’t defer taxes may be a better pick.

Retirement Savings Tips

• Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you do choose to use a 401(k), make sure to take advantage of any employer match available to you.

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