If you were to survey 100 Americans and pose the question: “Where should you put money for retirement?”, most would respond with “My 401(k) at work right?“. Because this believe is so common, the 401(k) is often the only investment account for the majority of Americans. Is this the best way to go? I don’t believe so. Let’s get into why.
The 401(k) is an IRS-qualified employer-sponsored retirement plan that allows employees to defer a portion of their salary on a post or pre-tax basis. Most commonly, contributions are made from pre-tax earnings and grow on a tax-deferred basis. Tax-deferred means the employee isn’t required to pay taxes on any appreciation in value until the money is withdrawn.
In recent years, the Roth 401(k) which allows for post-tax contributions has become more popular as more employers have made this option available. Because no taxes are due when withdrawals are made, this type of account is aimed at people who believe they will be in higher tax bracket at retirement than they are now.
Not a bad deal right? You get either tax-deferred growth or no taxes due at retirement. However, like most things in life, the 401(k) isn’t all sunshine and rainbows. Here are few reasons why you shouldn’t make it your only investment account.
Withdrawal Age Requirement
By relying solely on a 401(k), you’re essentially locking the money up until you’re age 59 ½ or older.
For both the traditional and Roth 401(k), you’re unable to make qualified withdrawals until age 59 ½. If you withdraw the money before then, the IRS will penalize you.
For pre-tax accounts, the penalty is 10% of the money withdrawn in addition to being taxed at your ordinary income rate. For most investors this means at least 35% of the amount withdrawn will go to the IRS. Ouch. For Roth 401(k) account holders, you’ll be hit with a 10% penalty on any earnings withdrawn before 59 ½. The only penalty-free money that can be withdrawn from a Roth 401(k) before age 59 ½ are the funds you contributed at least 5 years prior.
For example, assume that a 25-year-old contributes $5,000 to a Roth 401(k) and by age 31 it has grown to $8,000. In this situation, the original $5,000 can be withdrawn penalty free while she would pay a 10% penalty on the $3,000 gained during the 6-year period.
Fees
401(k) investors are often restricted to a small basket of mutual funds that may not meet their investment strategy. Many of these funds have fees of 1.5% or higher. That doesn’t sound like a lot but over the course of 20 – 30 years, it can end up being tens of thousands of dollars or more.
Pretty much all 401(k) accounts also charge a “record-keeping” fee on top of the mutual fund expense ratio. This fee is typically .08% – .20% but there are cases of it being even higher. Again, it doesn’t sound like a lot, but those small percentages add up over the span of an investor’s lifetime. Due to the fee structure, it’s no surprise that most investments in 401(k) accounts often underperform the general market.
Lack of Investment Options
Most 401(k) accounts offer very limited investment choices. As stated earlier, the investor is often restricted to a small basket of expensive mutual funds.
Other than company stock, most 401(k) administrators don’t permit the account owner to purchase individual stocks. So, forget building up that huge position in Apple, AT&T or Facebook, unless you happen to work for them. This is a big problem because there are great returns to be made by holding dividend paying stocks over a long period of time. Ask Warren Buffett how he feels about the Coca Cola position that Berkshire has held since the early 80s.
A Better Alternative?
If I’ve convinced you that the 401(k) as your only investment account isn’t the best approach, what’s a better alternative? Depending on your situation, a 50/50 approach to pre and post-tax investing can yield a more balanced and less expensive portfolio that provides more investment options.
The approach I prefer:
Because it’s pretty difficult to beat free money, first ensure enough is contributed to your 401(k) plan to receive the full company match. Free money is after all well, free money. If available, I’d next recommend fully funding a Health Savings Account (HSA) up to the annual limit. Follow that with fully funding an IRA up to the annual limit. There are several IRA types to choose from (Traditional, Roth, SEP-IRA, Simple, etc). Consult with your CPA to determine which option is best for your situation.
If you still haven’t gotten to 50% of your investment dollars after doing the above (obviously an income rock star), come back to your 401(k) and increase the contribution percentage to reach 50% of your annual investment dollars.
The remaining 50% is invested post-tax in a traditional brokerage account and consists of a combination of individual dividend-paying stocks and low-cost index funds. There are several great options for brokerage accounts from Vanguard, Schwab, TD Ameritrade and E-Trade. Vanguard recently announced they would allow commission-free trades for ETFs from other providers so they’re probably worth additional consideration.
Depending on your situation you might not be able to do all of this. For example, if you don’t have a high deductible health insurance plan, you can’t contribute to an HSA. Consult with your CPA and do what you can based on your income and situation.
To recap:
- Contribute to your 401(k) up to the match. Choose a low-cost mutual fund. One that tracks the S&P 500 is usually a safe bet.
- If you have a HDHP (High-Deductible Health Plan) contribute to an HSA up to the full amount allowable. See the contribution limits here.
- Contribute to an IRA. (Traditional, Roth, SEP-IRA, Simple, etc.)
- Come back to your 401(k) and increase the deferred income percentage to reach 50% of available annual investment dollars.
- Invest the remaining 50% post-tax in a traditional brokerage account.
This approach is more flexible since it provides you with the option for income prior to 59 ½ and allows you to put money into financial instruments other than mutual funds. If you decide you want to retire early or have some unforeseen need for capital, you’ll have a way to get it without incurring a large tax bill.
A great FREE tool I personally use for tracking my portfolio is Personal Capital. When you click this link to sign up for your free account, both you and I will receive $20. Every little bit helps right?
Legal Disclaimer: The information provided and accompanying material is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney, CPA or other professional to determine what may be best for your individual needs.