401 (k) accounts are a great tool for savers who want to supplement Social Security income in retirement. It’s a great idea to take advantage of employer matches and the automated savings provided by this account. However, you may want to consider a more balanced approach if you are contributing beyond employer matching.
Everyone’s situation is different, but there are certainly situations where the 401 (k) isn’t the only place you should put your retirement savings.
1. Taxes at retirement
People love the idea of avoiding tax today, and it’s one of the qualities that makes 401 (k) accounting so appealing. Eligible contributions are paid and grow tax-deferred. That’s great, but you have a built-in liability that grows over time. Withdrawals will be taxed as ordinary income in retirement.
The prevailing wisdom is that people will be in lower tax brackets in retirement than in their working lives, and that is usually the way it is. In retirement, you will no longer need the same income to replicate your lifestyle. You won’t need to set aside any of your income to save, there will likely be no housing or child-care payments, and Social Security will send out checks every month as well. All of this is working in your favor.
However, two key issues arise from these assumptions. First, lower tax brackets in retirement do not necessarily mean lower tax rates. Many Americans are convinced that tax rates will be higher in the future because of the continued deficit of federal and state governments. At some point, what is borrowed has to be paid back. If tax rates are significantly higher in a few decades, it might be unwise to delay taxation.
Second, it’s pragmatic to plan for lower income in retirement, but that doesn’t mean you should aspire to be in a lower tax bracket. Whether you are preparing for the costs of health care and a longer life expectancy or just trying to live a good lifestyle during these years when “every day is Saturday”, you may need to be preparing yourself for a higher income.
The solution here is balance. Spreading your retirement savings across different types of accounts will diversify your tax exposure. Consider using a Roth IRA if you can, that will provide tax free distributions. You can also use a regular brokerage account for long term growth, and this would be imposed on long-term capital gains rate rather than regular income rates. They are viable additions to your 401 (k), especially if you are a young person with dependents or deductible interest mortgage or student loans.
2. Low liquidity
Once your money goes into a 401 (k), it usually doesn’t come out until you’re 59 1/2 if you pay a 10% penalty. There are derogations for first-time buyers or those experiencing financial difficulties, but you shouldn’t plan for them unless it’s opportunistic. Your 401 (k) should be invested with a specific time horizon in mind, and this influences the appropriate level of volatility. If you plan to access these funds in a shorter time frame, your allocation will not match your goals.
Ultimately, you deprive yourself of your money for a long time when it goes into a 401 (k). It can be a blessing for people with bad saving habits, but this money is also not available when an emergency or an opportunity arises.
Again, Roth and brokerage accounts are good ways to balance growth and liquidity. Shares in a brokerage account can usually be sold and withdrawn within days (although this can be a taxable event if you have any earnings). Since Roth contributions are made after tax, you can withdraw up to the amount you deposited without incurring a penalty. Accessing earnings in a Roth account is another story, but it’s still more flexible than a 401 (k).
3. Investment options and fees
Your 401 (k) is subject to the conditions and investment options provided by your employer’s plan. Many 401 (k) plans offer plenty of mutual fund and ETF options that will do a good job for any retirement saver. However, you will generally not be able to buy individual stocks. Opening an IRA, Roth or traditional brokerage account on one of the popular platforms will open the door to thousands of potential investments, including your favorite stocks or niche ETFs for growth or dividends.
You also have no control over the charges in a 401 (k). These are negotiated by your employer, and small plans can incur relatively high management fees. There are regulations in place to keep these from being exorbitant, but you could be paying more than you would with a popular brokerage platform.