Introduction
Retirement planning is a crucial aspect of financial security, and for many Americans, a 401(k) is a key component of this. However, relying solely on a 401(k) is not sufficient anymore to retire comfortably. Not only is it not sufficient but there are major risks with relying on it solely. In this blog post, we will explore the limitations of 401(k) plans and why it is prudent to consider your options.
Contribution Limits
One of the main limitations of a 401(k) plan is the annual contribution limit. As of 2023, the maximum amount an individual can contribute to their 401(k) is $22,500. On top of employee contributions, employers are also limited in what they can contribute to your plan. While these amounts might be significant, they are probably not enough to cover all your expenses during retirement, especially if you have a higher standard of living or face unexpected costs. Think about it like this, you need your money to withstand almost 30 years and that’s if you do not want to leave anything behind for a legacy.
Contribution limits typically increase from year to year, but with the current inflationary environment and market expectations its hardly going to keep you afloat without other major contributions from your employer. $22,500 is only $1,875/mo and that’s before Uncle Sam comes calling for taxes.
Market Volatility
Another factor to consider is market volatility. 401(k) plans are typically invested in the stock market, which is subject to fluctuations. Economic downturns, recessions and even crashes can significantly impact the value of your retirement accounts, and the timing of this along with your retirement presents more challenges. Relying solely on the performance of the markets exposes you and your retirement to risk.
In addition to market risk, the timing of your retirement and the investments held within your 401(k) can greatly impact your ability to retire. Adequately allocating across your accounts leading up to your retirement is a must if you are even remotely considering retirement in the next 5 years. It’s important to understand the “buckets” you will be using to fund your retirement let alone if health issues happen during your retirement. Be prudent and make sure you are allocating across different asset classes to ensure a less risky retirement plan.
Limited Investment Options & Fees
Most employer plans offer a limited selection of investments to choose from, often these are pre-selected by the employer or plan administrator. While these options may be suitable for some individuals, they may not align with your specific goals, risk tolerance and timeline. Additionally, there are fees associated with 401(k) investments that can eat into your returns over time.
The fees within your 401(k) can have a drastic impact on your overall performance, with an average fee of up to 2% this can eat at your returns. So when looking at using your 401(k) you want to make sure you are getting the free money from your employer aka the match that they provide for each dollar you contribute to their plan. While, making sure you are weighing the risk vs. reward when it comes to the fees within that plan. Understanding the fees is just one of the many things we suggest when investing money with your employer.
Early Withdrawal Penalties & Taxes
401(k) plans are designed to encourage long-term savings, and as such, early withdrawals before the age of 59 ½ are subject to penalties. If you find yourself in a financial emergency or need funds for other purposes, accessing your 401(k) savings can be costly. Not to mention if you want to retire earlier than 59 ½ that means accessing these funds can be extremely costly. If you do retire prior to 59 ½ then you will be looking at other assets to fund your retirement until you can access the funds held within your employer’s plan, which will drastically change the way you look at retiring or “semi-retiring.”
In addition to the penalties of early withdrawals depending on the type of plan (pre-tax or after tax dollars) you will have a tax bill to pay each time you want to withdraw funds. Remember, Uncle Sam always comes calling and if you aren’t prepared come April you might be in a bind when it comes to your finances. This limitation restricts your financial flexibility and leaves you without an accessible source of funds when you need it most. Not to mention more costs during retirement because you neglected to factor taxes into your monthly or annual withdrawal from your employer plan.
Inflation
Inflation, as we all know, is the silent killer of any savings. Over time, the purchasing power of your money decreases, meaning that the same amount of money will buy less in the future. The way we like to say it is if your groceries cost $100 last year they might be $106 this year. While that $6 difference might not seem like a lot, over a long period of time it can have a real effect on your finances.
While a 401(k) may grow over time, it may not keep pace with inflation, potentially reducing the real value of your savings. Especially if you are using your 401(k) as another savings device and not using more growth focused investments, by allocating funds to cash or bonds within your 401(k) inflation risk over time increases without the benefits of tax deferred growth within different investments.
Conclusion
While a 401(k) and other employer retirement plans are undoubtedly an important retirement tool, it shouldn’t be relied upon as the sole means of funding your retirement. The contribution limits, market volatility, limited investment options, early withdrawal penalties, taxes and the impact of inflation all highlight the need for additional strategies to supplement your retirement.
To secure that retirement, consider diversifying your portfolio by not only investments but by exploring other accounts such as Individual Retirement Accounts (IRAs), taxable investment accounts, and other investment vehicles that can provide buckets for you to pull from as you look to use your money.
Remember, it’s never too early to start saving for retirement. By being proactive and planning ahead, you can build a solid financial foundation that will provide you with greater peace of mind in your golden years.
