Perhaps you’ve been told about the wonders of the 401(k) and you’re excited about investing. You’ve been told that you can achieve a wonderful retirement by using this investment vehicle. To some extent, this is true. However, there are five negative aspects of the 401(k) or 403(b) you must consider before jumping in.
What is a 401(k) plan?
But first, let’s do a quick recap on what this investment option actually is. The 401(k) is an employer sponsored “defined-contribution” account. It gets its name from the specific IRS code that describes it. Money is contributed by you, the employee. Funding for this account comes from your paycheck but can also be partially matched (added funds) from your employer (some do and some do not). Thus, the majority of the money comes from you, the employee.
401(k) plans are offered by “for profit” companies whereas 403(b) plans are offered generally by “non-profit” companies such as hospitals and public schools. They can invest in annuities, bond, or mutual funds
They are both “tax-advantaged” plans, where contributions are made before taxes are taken out, allowed to grow tax free, but later taxed when you withdraw as ordinary income. It’s taxed just like you would had you received a paycheck (whatever your tax rate is at the time of retirement).
Some benefits of these plans:
- Contributions are made on a pre-tax basis (avoids taxation when you put it in)
- Tax-deferred gains. This allows “all” your money you contributed to be invested and grow within your investment account. As your mutual funds/dividends make money, so do you. Waiting on paying these taxes can increase the long-term investment growth
- Its easy: set it up with your employer and you’re off to the races. They will dutifully begin taking out whatever percentage you want from your paycheck to begin funding this account (at my employer it started out as 3%).
Tip: starting with a higher percentage and electing to increase this percentage annually (generally offered within your plan settings) will often make it easier to accumulate wealth for those golden retirement years. Set it on auto and let it grow for you!
- They have higher annual contribution limits than other retirement options. For the year 2021 you can invest $19,500 per year (and up to $26,000 per year if you’re 50 and older).
- There may be a match: your employer may offer a percentage match, say 25% on the dollar up to 3% to 6% of an employee’s salary. In this case it might be wise to contribute enough to get the full match.
- Why? This is FREE money! Can you say free?
Drawback to using a 401(k) or 403(b)
There are certainly some negatives to using your employer sponsored plan. Here are a few.
1.) There are high fees
Some mutual funds within your plan can have high fees. This is a big negative of most 401(k)s. These fees are used for the costs associated with running the specific fund. For instance, there are manager fees, advisor fees, and advertisement fees. Yep, you’re included in paying for the marketing and running of the funds! Thanks and you’re welcome! There has been a lot of attention of these fees in the last few years so many have come down but still pay attention. Look at the funds “expense ratio” which will give you a percentage. If the funds has a fee of 1% or more (1% is $1 for every $100 in your account) I would personally look elsewhere.
Tip: See if your plan has an “Index Fund” within it. Generally, these type of funds follow broad market indexes and have much lower fees. One of my favorites is Vanguard. Their index funds offer very low fees. Think 0.09% to 0.14% (other funds can be 0.5% to 1% or even higher!).
Why? Because higher fees mean less money in retirement! Generally, these funds perform very similarly so why pay high fees if you don’t have to?
2.) You have limited options
Within most of these employer sponsored plans, there are limited choices to you. Your employer chooses the funds available to you (out of the many options available). Many offer “target-date funds” which are investments that change the allocation of stocks/bonds according to your age but they often have higher fees.
There are generally a few large, mid-cap, and small-cap offers as well. For most people these will be fine (especially if they offer “Index” funds with lower fees within them). But if you want more options, you’re often out of luck.
For instance, at my employer we are offered a mix of large, mid, and small cap funds. Fortunately, they do offer an “index” fund within each so the fees are low. However, I cannot invest in specific stocks or ETFs.
3.) You’re stuck with the tax rate (whatever it may be) at the time of your withdrawals
Since the 401(k)s are tax-deferred, which reduces your taxable income from the start, the government will want their share when you start withdrawing the money. If you’re actually in a lower tax bracket in retirement, this might work for you.
However, and this is a big one, tax rates might actually be higher tomorrow than they are today. What? Many experts feel that with the national debt ballooning and the increase printing of money, tax rates will need to rise to meet our obligations later on. It would be worth meeting with a financial advisor to get professional advice when considering this.
Tip: One option is to invest in an employer sponsored 401(k) Roth or 403(b) Roth if available. With these accounts you pay taxes up front and not in retirement. For instance, with my employer they recently started offering a Roth version of my 403(b).
4.) Penalties for withdrawing early
So, these plans are designed for retirement in mind. Meaning, they don’t want you to touch this money early (which is designed for your benefit so you’ll actually have money to live on later in life).
So, yes, there are some restrictions such as withdrawing your money before your 59 ½ years old. If you need this money sooner, you’re going to have to pay to access it. As said, the government has designed this to be a “retirement account”, thus they will ding you 10% (along with your normal tax rate at the time) if you withdraw money before this age.
One prevailing “theory” is that you “should” be in a lower tax bracket in retirement (since you’re making less money than when you were in your working years). The theory holds that you will then be paying lower taxes. You’ll have to discuss this with your personal advisor because you may not actually be in a lower tax bracket depending on your situation.
5.) You are required to withdraw your money at some date regardless
Yes, you heard that right, with these accounts you will be “required” to begin withdrawing (based on a percentage according to your age) money starting at the age of 72 years old. Meaning, even if you don’t need the money, you’ll have to take it out or suffer a whopping 50% tax on the amount you were required to withdraw! Ouch!
Many consider this to be a massive negative aspect of the 401(k) or 403(b) system. If you’re lucky enough to have funds so that you don’t need to pull from this account, too bad. You’re forced to (or suffer the consequences), but for some people this may push them into another tax bracket unwillingly.
Summary
Regardless of your feelings toward employer sponsored retirement plans, they can certainly be a great tool for building wealth for your retirement. Love them or hate them, it’s worth considering your options. You only get one chance at retirement. No going back and doing over. Plan now so you’re well equipped and can make the best decision for your particular situation.
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