You’ve certainly heard its praises. Indeed, the 401(k) retirement account has been hailed as a game-changer since its inception over 40 years ago, establishing an effective means of saving for retirement once pension plans were no longer up to the task.
Such employer-sponsored plans aren’t necessarily your best first choice for building a retirement fund, however. There are reasons to select other savings options. Here’s a rundown of the top four reasons you might not want to bother participating in your employer’s 401(k) plan, and instead do your own thing.
1. Your investment options will likely be limited
Like doing things your way? Then you won’t be thrilled with most 401(k) plans. The bulk of them are managed by mutual fund companies, with most of those companies limiting your investment choices to their family of funds. In fact, you may not even have access to that fund company’s entire fund lineup. Even in cases where a plan is offered through a full-blown brokerage firm, you’ll likely be limited to a select number of mutual funds of its choosing.
If you want to be able to own any combination of mutual funds, stocks, exchange-traded funds, or bonds, you’ll have to do that through self-directed options like a traditional IRA or a Roth IRA.
2. Your employer might not match any of your contributions
It’s not particularly common, but it’s entirely possible that your employer won’t match any portion of your own contributions to a 401(k) account. If this is the case — you’ll want to check with your plan’s administrators to be sure — it negates one of the most compelling features of participating in a company-sponsored plan.
Don’t misunderstand. For the most part, there’s no such “free money” in funding your own IRA outside of a 401(k) plan either. In the absence of this perk, however, you’re limiting your options — as well as crimping your withdrawal flexibility (more on this in a moment) — for no additional benefit.
3. You might actually want to pay your taxes now
It sounds strange to suggest you may want to pay taxes on your income now, when you’ve got the option of deferring taxes on income contributed to a 401(k). But there are scenarios in which you might be better off doing exactly that. Chief among these scenarios is the possibility that you’ll be in a much lower tax bracket once you retire than you’re in while you’re working. One alternative is a Roth IRA that doesn’t provide any sort of tax break now, but offers tax-free withdrawals when that time comes.
Don’t take such a decision lightly. You’ll want to do some rather serious figuring to make sure it makes the most financial sense for you. To figure correctly, you’ll need to make a detailed retirement income plan, identifying all sources of that income and what you’ll actually owe in taxes when the time comes. For most individuals, postponing your tax benefits isn’t a good enough reason to not participate in a 401(k) plan.
4. Withdrawal rules can be restrictive, and complicated, for survivors
All individual retirement accounts have their own strict rules about taking money out of them. Broadly speaking, though, 401(k) plans’ withdrawal rules seem to be the most restrictive, and the most complicated.
Like most IRAs, you generally can’t take money out of a 401(k) account without an early withdrawal penalty until after you’ve turned 59 1/2, although there are a handful of hardship exceptions that sidestep this 10% penalty. Also like most IRA accounts other than Roth IRAs, you must start taking your required minimum distributions in the year in which you turn 73.
The matter can get complicated if you’re married and your spouse is named as beneficiary in the event of your death. Thanks to the SECURE Act that passed in 2019 and was updated in late 2022, spousal beneficiaries can either roll that account over to their own IRA where normal distribution rules apply, or take it in a lump-sum payment… which is a fully taxable event.
In cases where the deceased has already begun taking required minimum distributions, surviving spouses can continue collecting those withdrawals based on their deceased spouse’s original payout schedule by simply leaving the 401(k) as it is, and where it is.
Things become even more complicated than this if your beneficiary isn’t your spouse… say, like a child or grandchild. The same basic inherited 401(k) withdrawal rules apply, including the option to take a fully taxable lump-sum payment. You can also leave it with the plan administrator, although this option still requires a withdrawal of the entirety of the account within five or 10 years (depending on the survivor’s age and other factors, like disability) of the original account owner’s death.
That’s a lot of potential decisions for a survivor to make about a retirement account managed by a plan administrator that may or may not be all that interested in helping.
Think it through carefully before deciding not to
Don’t misread the message. Even with their actual and potential downsides, most 401(k) plans are great vehicles to help you save for retirement. They’re a bit more complicated, but they can be navigated. Your employer probably does match some of your contributions to them. And, even if your options are limited to one family of funds, you can generally find investments among them that perform well enough.
The point and purpose here is simply helping you pre-identify potential pitfalls before they surprise you.
Still, if your total contributions to a 401(k) plan are only ever going to be minuscule — and if you’re instead making the maximum annual contributions to a traditional or Roth IRA — participating in a 401(k) plan may well be more trouble than it’s worth. It might be wiser to just take the money you would have put into a 401(k) and aim to put it into a brokerage account instead, even though it’s taxable. At the very least, you’ll have more options to invest it. You’ll also have easy access to it should you need it.
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Source: The Motley Fool