Yahoo Movies Retirement Savings: 7 Drawbacks of Using Only a 401(k)
When it comes to retirement planning, 401(ks) are often touted as one of the best ways to prepare for that day when you are no longer drawing a work-related income. While 401(k)s have many benefits, if you’re relying on them exclusively for retirement, you might be missing out on the benefits of other retirement strategies.
How To Go From Broke in Your 40s to a Millionaire in Your 50s: 8 ‘Late Start’ Retirement Tips
Learn: The Simple, Effective Way To Fortify Your Retirement Mix
Here we look at the biggest drawbacks of using only a 401(k) for retirement.
Penalty on Early Withdrawals
One big drawback of a 401(k) is that if you withdraw money from the account before you reach the age of 59½, you’ll pay a 10% penalty.
Joe Calvetti, a CPA and founder of Still River Financial Planning, said, “So, if you’re looking to retire early or have other goals you are saving for that would require using some savings before you reach that age, you likely don’t want 100% of your savings in a 401(k).”
An alternative is a taxable brokerage account, he explained.
“There are no restrictions on when you can withdraw your money or what it can be used for,” he said, “and if you hold investments in the account for longer than one year, you could qualify for advantageous capital gains tax rates on any increase in the value.”
Check Out: 3 Things You Must Do When Your Savings Reach $50,000
Limits on Investment Choices
Another drawback of a 401(k) is the restrictive nature of investment choices within the plan, said Alan Beard, managing director of Interlink Capital Strategies.
“These plans typically offer a predefined selection of mutual funds, leaving participants with limited flexibility to invest in alternative assets,” he said. “The lack of investment diversity can hinder the optimization of your retirement portfolio.”
Instead, Beard said, some people explore self-directed 401(k) plans, “which provide more control over investment options, including real estate, private equity, and precious metals.”
Uncertainty About Future Taxation
Yet another often-overlooked aspect of concern with 401(k) plans is the uncertainty surrounding future taxation, Beard said.
“While traditional 401(k) plans offer tax-deferral benefits,” he said, “it’s unclear how tax rates may evolve over the decades until retirement.”
To mitigate this risk, he suggested individuals consider a Roth 401(k) or backdoor Roth IRA conversions. “These vehicles offer tax-free withdrawals in retirement, providing a hedge against potential tax rate increases.”
Social Security Coordination
Many people don’t realize that 401(k) withdrawals can impact their Social Security benefits, Beard pointed out.
“Once you reach the age of 70½,” he said, “required minimum distributions from a 401(k) can push your income above certain thresholds, resulting in a portion of your Social Security benefits becoming taxable.”
To optimize your retirement income, Beard recommended coordinating 401(k) withdrawals with your Social Security claiming strategy, so as to reduce the tax impact on your benefits.
Limits in Managing Tax Burden
By saving only in tax-deferred vehicles, you would find yourself with limited options in retirement when it comes to managing your tax burden, said Rob Duncan, owner of Global Impact Wealth Management.
“All funds that come out of a qualified retirement plan are taxed as ordinary income,” Duncan said. “Yes, they are reducing their taxable income now while making contributions, but there is no guarantee they will be in a lower tax bracket in retirement, taxes could conceivably go up. Tax optionality is a valuable asset in and of itself.”
For example, he pointed out that a married couple could generate $100,000 in retirement income, with $20,000 coming from a Roth IRA, tax free. The clients would have just $80,000 of taxable income, keeping them in the 12% federal bracket and not subjecting the remainder to taxation at the 22% federal bracket.
Duncan recommends utilizing Roth 401(k) options inside their plans as well as a taxable investment account. “In this way they may be able to generate the same level of income in retirement, but at a lower tax rate.”
High Fees
Some 401(k) plans have high administrative and investment fees, which can erode investment returns over time, according to Zachary Hellman, owner of Tax Prep Tech, a small accounting firm.
Required Minimum Distributions
Additionally, with a 401(k), if you wanted to keep your money invested past the age of 72, you’re out of luck, Hellman said.
“401(k) plans have RMDs starting at age 72,” he said, “which can be a drawback for individuals who do not need the funds and prefer to leave them invested.”
He said people should consider adding IRAs or Roth IRAs to diversify investment savings and Health Savings Accounts to offer tax benefits for medical expenses.
“Ultimately, the best approach depends on an individual’s financial situation, goals and risk tolerance,” Hellman said. “It’s important to consult with a financial advisor or tax professional to develop a comprehensive retirement savings strategy.”
More From GOBankingRates
This article originally appeared on GOBankingRates.com: Retirement Savings: 7 Drawbacks of Using Only a 401(k)
