If you have access to a 401(k), consider yourself lucky to be able to invest in one of the most powerful retirement accounts out there.
The 401(k) has plenty of perks: high annual contribution limits, employer matching contributions, and automatic enrollment when you start a new job, to name a few. It's not perfect, however, and there are advantages to investing in other types of retirement accounts as well. While you don't have to quit saving in your 401(k) altogether, there are a few downfalls to only investing in a 401(k).
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1. You may be paying high fees
Whether you realize it or not, you're paying fees on your 401(k) investments. All types of retirement accounts charge fees, so this isn't a problem that's isolated to 401(k) plans. However, with a 401(k), you may be stuck with higher-than-average fees.
Because your 401(k) is tied to your employer, you don't have much choice in the type of plan you invest in — that decision is up to your plan administrator. This is unlike investing in an IRA, where you can choose from any brokerage that offers this type of account.
The average 401(k) plan charges annual fees of 1% of assets under management, according to a report from the Center for American Progress. If your plan charges higher-than-average fees, you may be stuck with them if you want to keep contributing to your 401(k).
2. You could miss out on tax advantages in retirement
When you invest in a 401(k), you get a tax deduction upfront when you make your initial contributions. Then once you retire and start making withdrawals, you'll pay income taxes on your distributions.
That's not necessarily a bad thing, but some investors prefer the Roth IRA for its tax advantages. Although your initial contributions are taxed with a Roth IRA, your withdrawals in retirement are tax-free. Investing in a Roth IRA could save you money if you expect your taxable income to be higher in retirement than it is now, because you'll pay taxes now when you're in a lower tax bracket, then enjoy tax-free withdrawals later when you're in a higher bracket.
3. You have limited investment options
Again, when your 401(k) is tied to your employer, you have limited choice in the specifics of your plan. This also means you don't have as many investment options as you would with an IRA.
With a 401(k), you typically have a variety of mutual funds to choose from. For many people, that's not a problem. But if you're a hands-on investor who wants more control over your investments, the limited options with a 401(k) can be frustrating. For that reason, investing in an IRA can be advantageous because you're able to invest in stocks, bonds, ETFs, annuities, and other investments not available through a 401(k).
When should you invest in a 401(k)?
All this isn't to say that you shouldn't invest in your 401(k), because it has plenty of advantages. However, there's no rule saying you can't invest in both a 401(k) and IRA, and sometimes that's the wisest choice.
You may, for example, invest enough in your 401(k) to earn the full employer match, then save the rest of your cash in a Roth IRA for the retirement tax advantages. Or if you're a super saver, you might max out your IRA first and then contribute your extra cash to your 401(k).
Every type of retirement account has its advantages and disadvantages, and understanding the limits of different accounts can help you make better investing decisions. Though the 401(k) can be incredibly powerful, if it's the only type of account you're investing in, you could be missing out on ways to maximize your retirement savings.
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