If you’re just getting started in your career, you’ve probably heard experts recommending that you start a 401(k). For many, this is the first step to saving for retirement. In 2021, 51% of the workforce contributed to a 401(k), according to data from the U.S. Bureau of Labor Statistics.
But is it the wisest choice? Certainly, it’s a start if your employer is one of the 68% to offer a plan. And, if your employer is matching your contributions, that’s free money you don’t want to leave on the table.
But investing in your 401(k) and ignoring other investment options for retirement could leave you with less than you need to live a comfortable life in your later years. Here are five ways your 401(k) could actually hurt your retirement finances.
401(K) Withdrawals Could Make Your Social Security Taxable
When you begin taking distributions from your 401(k), which you are required to do after you reach the age of 73, this income factors into the maximum you can earn before your Social Security benefits are taxed.
According to IRS law right now, your Social Security benefits are not taxable as long as you make less than $25,000, or less than $32,000 for couples who file jointly. At that point, you might have to pay taxes on as much as 85% of your benefits. “Countable” income that factors into the equation includes half your Social Security benefits, plus any taxable income (including 401(k) distributions) and some non-taxable income.
If you have already accrued a hefty amount in your 401(k) or other accounts, such as traditional IRAs or SEPs, it pays to speak to a financial advisor to see how these required minimum distributions could impact your income and taxes in retirement. Roth IRAs, on the other hand, have no RMDs.
You Could Face Penalties for Early Withdrawals
If you are on track to retire early, don’t count on using 401(k) distributions to fund it. You could face penalties, typically of 10%, if you withdraw the money from your 401(k) before you reach the age of 59 ½.
Limited Investment Choices
An employer-sponsored 401(k) plan often doesn’t have the vast array of investment options that you could find with other plans. You usually have to choose from a limited number of fund options.
On the other hand, by working with a financial advisor, you can create a diverse portfolio of stocks, bonds, ETFs, and mutual funds that make sense based on your risk tolerance and retirement goals.
Limits to How Much You Can Save
A 401(k) can reduce your taxable income now, giving you more take-home pay when you might need it the most. However, the IRS has imposed limits on how much you can contribute on a tax-deferred basis.
These limits change annually. In 2023, you can contribute up to $22,500 to your 401(k). Employees over age 50 can make an additional “catch-up contribution” of $6,500 per year in 2023.
While some people might dream of being able to save that much annually for retirement, others can far exceed this contribution. If your goal is to ramp up your savings beyond 401(k) limits, consider other options, which may or may not be tax-deferred.
Some 401(k) Plans Have Fees
As if all these limitations aren’t bad enough, some 401(k) plans have management fees. That’s money coming right out of your retirement savings. Sometimes, the fees are nominal and easily offset by employer contributions and other gains. But, it pays to speak to your HR department or financial advisor to find out how much you’re paying and what services you’re receiving (if any) in exchange.
Bottom Line
A 401(k) can offer a healthy start to retirement savings, especially if your employer matches contributions. But, as your salary increases and you have more to invest, speak to a financial advisor to help you diversify your portfolio.