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Saving for retirement is much like going to the dentist. We all recognize the importance, but it’s easy to delay because it’s uncomfortable and tedious. Although investing can seem daunting, a 401(k) is an excellent starting point and a strong savings incentive. However, 401(k)s are far from flawless.
Despite the usual criticisms of 401(k)s, if your employer provides one, you should enroll in it. Many companies offer a match, which means they’ll match a percentage of your savings in the 401(k) plan, up to a certain limit. That’s essentially free money, so you should aim to get as much of it as possible. To maximize the match, save enough. While not perfect, they’re better than nothing, and for many, that’s the alternative.
The Fees Are Excessively High
Perhaps the most common gripe about 401(k)s is the expensive fees that come with them. In the world of investing, these fees are known as expense ratios. The expense ratio refers to the cost of operating the investment, represented as a percentage. Firms such as Vanguard and Fidelity charge less than 0.10% on many of their funds. In contrast, 401(k)s often have expense ratios reaching as high as 1.5%.
The problem is, you have little control over 401(k) fees, as you only have so much influence over the investments you choose. “But a tiny percentage? That’s insignificant,” you might think. “What’s the big deal, penny-pincher?”
You’re right, it’s a small percentage. Tiny! But over time, 1.5% can accumulate to a large amount. Imagine you invest $100,000, and over 20 years, you earn a return of 7%. With a 1.5% fee, your return will be $291,000. However, with just a 0.10% fee, that same investment grows to $379,799. That’s an $88,000+ difference.
This is exactly why so many investors despise 401(k)s: the fees are excessive. You can use this investment fee calculator to compare expense ratios. If you’re unsure of how high your 401(k) fees are, you can either find the information on your statement or use a tool like FeeX to analyze your portfolio and determine the fees.
This isn’t to suggest that you shouldn’t invest in your 401(k) entirely. You should still save enough to get the match. After all, free money is a fantastic deal, even with the fees involved.
Once you’ve maximized the benefits of that employee offer, though, there’s little reason to continue saving in your 401(k). At that point, it makes more sense to open an Individual Retirement Account (IRA) and invest your money there, in a long-term, ”set and forget” investment strategy. This allows you to invest in more affordable options.
Your Investment Choices Are Restricted
When you spend more money on items like shoes or a mattress, you typically get better quality. However, that’s not always true with investments.
A higher expense ratio doesn’t necessarily mean your investments will perform better than those you could select independently. In fact, it’s often argued that 401(k) funds are actually worse than those you might choose on your own. There’s also the issue of fund diversity. While basic stocks and bonds are a good place to start, it’s wise to invest in other assets as well, yet most 401(k)s limit your options to just a few. As Investopedia notes, they are designed to be simple, not diverse.
Review your 401(k) statement to see what types of funds you’re invested in. Tools like Personal Capital and Mint Investments can also help you break it down. Personal Capital will show you what you own compared to what you should own, based on factors like your age and risk appetite. Once you understand the ideal composition of your portfolio, check your 401(k) to see if similar investments are available. For instance, if Personal Capital recommends more international stocks, look for an international stock fund in your 401(k). If it’s not there, consider using an IRA to buy the investments you need.
That 'Free Money' Isn’t Truly Free
While it’s generous of your employer to offer a 401(k) match, it’s not entirely selfless. Companies that provide employer matches often offer lower salaries, as shown by data from the Center for Retirement Research. This is particularly true for higher-income workers (the top 40% of the income bracket). According to their report, the Center for Retirement Research states:
...for male workers, an extra dollar in employer 401(k) contributions replaces 90 cents of wages for those with high incomes, but only 29 cents for those with lower incomes...For female workers, an additional dollar in employer 401(k) contributions replaces 99 cents of wages for high-income earners, but just 11 cents for low-income earners. These findings suggest that the tradeoff between fringe benefits and wages varies depending on income level.
For high-income workers, additional 401(k) contributions are nearly entirely offset by reduced wages.
Furthermore, as former hedge fund manager and author James Altucher highlights, you need to be fully vested to access these funds. Employers don’t just invest your money upfront. They hold it and spread the benefit over a period of years, up to six in total. Essentially, you may need to stay at your job for six years, or else this “free” money disappears.
You Don’t Get to Choose Your Tax Benefits
All retirement plans come with a tax advantage, but there are two main types of benefits. Certain retirement plans, like Traditional IRAs, are tax-deferred. This means you can subtract the amount you save from your taxable income, which lowers your taxes for now. In other words, you’ll pay less tax at present, which is great if you need to save right away. However, you’ll still pay taxes on the saved amount eventually—when you withdraw it, likely during retirement.
Other retirement plans, such as the Roth IRA, don’t provide this benefit. Instead, they offer tax-free growth, meaning you pay taxes as usual now, but none when you take out your funds in retirement. Your investment earnings grow tax-free. It’s a great deal, and many experts suggest the Roth for its tax-free growth advantages.
With a 401(k), you get a tax advantage, but it’s typically the tax-deferred option. Although Roth 401(k)s are becoming more popular, in many situations, you don’t have a choice—you must defer your savings and must pay taxes later. In other words, when you withdraw from your 401(k), you’ll be required to pay taxes. While a tax advantage is still beneficial, it’s another complaint about the 401(k): you don’t always have control over your tax benefits.
However, if you want to create more balance, you could open a Roth IRA alongside your 401(k). As we’ve already mentioned, it’s wise to open an IRA for diversifying your portfolio and avoiding high fees, so why not go with a Roth IRA to maximize the benefits of tax-free growth?
Once again, 401(k)s are great for getting your retirement savings started. They motivate many people, who might not otherwise consider investing, to begin saving for the future. They also simplify the investing process. However, this simplicity comes with a trade-off. Once you understand the plan, you’ll know how to navigate its drawbacks and limitations.
Illustration by Sam Woolley. Photos: Pixabay, Unsplash, energepic.com, Kaboompics
