You may be saving more with easy-to-contribute retirement savings vehicles, but you’re giving up a lot of flexibility.
Understanding your 401(k): How it works and why it matters.
What is a 401(k) plan? Key benefits and how to maximize your savings.
This premise sounds great. The more money you save for retirement during your working years, the larger your retirement nest egg will be. Contributions to a workplace retirement account are also tax-deductible, making it a little easier to direct some of your income toward these vehicles, even if it’s for psychological reasons.
However, if you’re planning on maximizing your 401(k) account contributions as much as possible, you might want to take a step back and reevaluate that idea. There are downsides to stashing money too aggressively in this type of retirement savings account (in fact, there are several downsides, but they all fit into one category).
This means that 401(k) accounts are much less flexible than other accounts. Let’s see why and what to do about it.
Potential Downsides of Stashing Money in a 401(k)
Don’t get me wrong: 401(k) plans have distinct benefits. The most important of these is the amount you can donate. This year, all participants in such plans can put up to $23,500 of their income into one of these workplace retirement accounts, and those ages 50 to 59 and those 64 and older can add an additional $7,500 (bringing the total up to $31,000). Lucky workers between the ages of 60 and 63 have the option to make a ‘super’ catch-up contribution of $11,250, increasing their maximum annual contribution to $34,750.
And that’s just a portion of the money employees put into their 401(k) accounts. Most employers also put a portion of employee contributions toward their own retirement savings, up to 6% of each employee’s gross income. Some lucky employees have reached the legal limit of $70,000 in total annual contributions to their 401(k) accounts this year.
Nevertheless, there are debatable drawbacks to making the most of workplace retirement savings options. As mentioned earlier, these vehicles can be very inflexible in some ways.
One drawback is the limited number of investment options available within most 401(k) plans. In most cases, these plans are managed by mutual fund companies, and in most cases, your only option is to invest in mutual funds rather than individual stocks.
This will probably work for most people (maybe a simple index fund is the best choice, or maybe a target date fund is best). However, if you consistently pick the right stocks, your 401(k) account can underperform other investments.
Funds held in a 401(k) account are also more difficult to quickly access and sometimes cost more than assets held in a traditional IRA. And it’s certainly more so than funds held in brokerage accounts.
Ideally, you wouldn’t want to remove money from your retirement account before you actually retire. But things happen in life. Sometimes unexpected expenses arise and you have to do what needs to be done.
Early withdrawals from non-Roth retirement accounts (before you reach age 59 1/2) are almost always taxed as income and typically subject to an additional 10% penalty, but withdrawing money from a 401(k) account requires both time and a significant amount of paperwork. And, in some cases, your employer may require you to first take this distribution in the form of a loan and then repay it to you through payroll deductions, which does not necessarily solve your current financial problems.
In contrast, assets and money in a regular IRA held at a brokerage firm like Charles Schwab or Fidelity can often be turned into a payable check within just a few days. No hassle. All you have to do is file your tax liability by April 15th of the following year.
It’s also worth mentioning that while there are some hardship exceptions that waive the 10% penalty for early withdrawals for 401(k)s, there are even more exceptions for IRAs. That means 401(k) plans typically don’t allow penalty-free withdrawals for expenses related to higher education, withdrawals of up to $10,000 to fund your first home purchase, or withdrawals for health insurance costs if you lose your job. Traditional IRAs and Roth IRAs both offer all three.
In this vein, even if maxing out your 401(k) means you don’t have any short-term emergency funds at all, it may be better in the long run to keep your funds a little more liquid so you can buy time to weather emergencies without having to tap your retirement accounts.
Finally, while the idea of lowering your taxable income now by making tax-deductible contributions to a tax-deferred vehicle sounds great on the surface, it may not necessarily be the best choice for you. A Roth 401(k) might be a better option. I don’t We will provide you with a tax break while you donate, but do Provides tax-free withdrawals after retirement.
Broadly speaking, you should pay income tax on your retirement savings when your taxable income is at its lowest and avoid income tax when your income is at its highest. It may be now, but it is It was done Please come later.
The only problem? Not all employers offer Roth 401(k) options. Vanguard, a leading mutual fund and retirement plan manager, reports that as of the end of last year, only 86% of the companies it manages with retirement plans offered access to Roth 401(k) accounts. If the Roth is your best choice, maxing out your non-Roth 401(k) contributions will only make you more financially challenged in the long run.
Most people will want to do a little bit of both
Don’t look at comparing retirement savings options from an extreme “either-or” perspective. You’ll probably use a hybrid approach that combines savings in a 401(k) account with savings in an IRA. This combo approach also has the potential to blend Roth and non-Roth retirement savings vehicles.
The first priority in your savings strategy is to put enough money into your 401(k) to ensure you qualify for the maximum matching contribution your employer wants. Once vested, it’s truly free money. Where you store it will then be determined based on your specific plans and expectations.
No matter how and where you save for retirement, try to save as much as possible without restricting your access to cash.
Charles Schwab is an advertising partner of Motley Fool Money. James Brumley has no position in any stocks mentioned. The Motley Fool recommends Charles Schwab and recommends the following options: December 2025 $95 short calls on Charles Schwab. The Motley Fool has a disclosure policy.
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