One of the biggest advantages of a 401(k) retirement plan is that you make contributions tax-free, with tax payments deferred until 20+ years down the line when you start making withdrawals. This provides some relief in the present and you can put money aside without worrying about tax deductions. It’s no surprise then that these types of retirement account significantly increase how much you can save.
There’s one major drawback though; the benefits you enjoy now often come at the expense of your future earning capacity, and you may end up with less money than you anticipated. So, before depending on a Tax-Deferred Retirement Accounts to cover your post-work expenses, here are five things you need to know:
1. You may end up paying more in taxes in the future
Yes, it’s great to save up for your retirement and not pay any taxes as you do so. In addition to investing more money toward the future, you also reduce how much of your current income gets taxed. Twenty years down the line, however, the IRS will be waiting for their share. And this time, tax will be deducted on the total amount you contributed plus any interest gained on your contributions.
In this case, deferring your taxes becomes a disadvantage. The situation becomes even worse if you were in a lower tax bracket while contributing to the retirement account. It means you deferred when your taxes were low only to pay the IRS when they got higher. And if you invest your retirement savings smartly, the goal SHOULD be to grow your account enough to move to a higher tax bracket.
2. The fees are often astronomical
If your tax-deferred retirement account is sponsored by your employee, then extra charges are something else to watch out for. Depending on certain factors, you may be charged investment fees, plan administration fees, service fees, and more. These fees add up very quickly, and the smaller your company, the more you may end up paying.
An alternative would be to contribute to the employer-sponsored plan up to your company match. Then, the rest can be placed in tax-exempt individual retirement accounts that offer more flexibility and earning capacity with lower fees.
3. There are limited investment options for your savings
With 401(k) plans, your retirement account is restricted to some exchange-traded funds (ETF) and mutual funds. This is done to minimize the plan administration fees discussed above and ensure adherence to regulations laid down by the Employee Retirement Income Security Act (ERISA).
As a result, your investment options are limited. If you learn about a trustworthy investment opportunity that you’d like to subscribe to with your retirement savings, it has to be offered by the plan. Otherwise, no matter how profitable or reliable the investment is, you can’t take advantage of it. Please note that some 401(k)s offer self-directed brokerage that increases your investment choices, but you’ll have to pay even more fees to access them.
4. Contributions follow a schedule with little room for flexibility
A 401(k) plan follows a strict schedule, no matter what’s happening in the market. This strategy is based on dollar-cost averaging – a belief that if you make small purchases periodically (and regardless of market highs and lows), you’ll make enough money to be profitable. Of course, the strategy doesn’t seek to maximize your savings. Even if they wanted to, with pooled 401(k) plans, there’s no room for that level of flexibility.
On the other hand, an individual retirement account gives you more control over how savings are invested. Depending on market conditions at the time, you may ask your account manager to hold off on making a play or accelerate your schedule to lock in more gains. This flexibility means you can make more money and take advantage of market highs and lows, maximizing your savings as a result.
5. Emergency withdrawals attract heavy fines
The goal of a retirement account is to save for the future. But in life, emergencies happen, and you may need to take extreme measures to keep your finances under control. For situations like these, you need a retirement account that doesn’t punish you for withdrawing early. A 401(k) plan carries a 10% penalty if you withdraw before 59.5 years. And that’s not all; you’ll also pay income taxes on any amount you take out.
Alternatively, if you had your savings in a tax-exempt individual retirement account, you can withdraw your contributions free of penalty charges and without paying any taxes. In addition to coming in handy during extreme situations, this gives you more control over your savings.
As good as a tax-deferred 401(k) plan is, some features make it less than optimal for some people. If you want more control, more flexibility, and a higher earning potential, you may be best served with an individual retirement account. And if you want to withdraw your savings without paying taxes or exorbitant fees, look into a retirement plan with tax exemptions.
In the event that your workplace matches 401(k) contributions, you may choose to enjoy the best of both worlds. Get your 401(k) match and look into saving the rest in individual retirement accounts that let you invest according to your risk appetite.
