It might be time to start admitting that the 401(k) is not all it’s cracked up to be.
What was once heralded as the future of retirement savings and the heir to the pension fund throne when it was introduced way back during the Reagan era may be falling short of some of its expectations.
Since one of the early champions of the 401(k) implied earlier this month -- somewhat regretfully -- that the account has failed to live up to its initial promises, and that it was never meant to replace traditional retirement investing options in the first place, it’s kind of disappointing to hear. Disheartening, actually, especially if you’ve been making an employer-sponsored 401(k) your main retirement account. But is it really all that surprising?
The report goes on to state that those who started socking away cash decades ago and are approaching retirement age are probably set; you’ll have saved an average $304,000 in your 401(k) and rolled-over accounts if you’re in your 60s. But the 401(k) as we know it may not be well equipped enough to keep up with the pace of the modern financial world.
For one, at least 30 million people have zero access to a retirement savings fund because their employer doesn’t offer one, presumably because of the cost of providing and administering a plan. There are also broader forces at work that are making a well-funded retirement out of reach, like longer life spans today than 30 to 35 years ago, or the fact that many companies are reluctant to cover retirees’ healthcare costs.
Wages have also leveled out and can’t keep up with the rising cost of living. Couple that with low interest rates that may weaken dividend yields, and your 401(k) may seem like a wholly dated, retro savings account that doesn’t have as much impact as it used to.
Let’s not deny the benefits of a well-supported, well-funded 401(k) (named as such for the tax code it’s based upon). You’ve got generous annual contribution limits up to $18,000. Your employer may offer to match the funds in your account up to a certain percentage, bolstering your savings. (Tax-deferred, of course.) You can automatically and easily enroll with few hoops to jump through. And you can roll over your earnings into an IRA.
But let’s play the devil’s advocate and seriously consider if a 401(k) really is a viable product to invest in anymore. If you don’t have access to an employer-sponsored retirement account, you’ll need to seek out an alternative anyway, like a Traditional, Roth or SEP IRA. But if you have one in place, you should be aware of some 401(k) drawbacks before looking at some other savings options.
401(k)s: Are they worth it?
Some downsides to the 401(k):
Fees can be expensive
The average 401(k) plan levies fees totaling 1 percent of your assets held, according to data from the Center for American Progress. That may seem like quite an insignificant drop in the bucket, but those costs can add up as the years go by; at that rate, the average American worker will pay nearly $139,000 in 401(k) fees over their lifetime. That’s money you could have had in your pocket. These fees are usually tied to administrative and service functions needed to run a 401(k) plan.
Then there are early withdrawal fees. Short on cash and thinking about dipping into your retirement reserves? No problem, you’ll replenish the money over time, right? Make a withdrawal before the official withdrawal age of 59 ½, and you’ll get hit with a 10 percent penalty surcharge. In this case, a 401(k) is hardly different from an IRA: early withdrawals are allowed, but frowned upon. If you’re looking for liquidity, you might seek out another alternative.
401(k) gains may show instability
Dollar-cost averaging (DCA) has its supporters, advised as a risk-reducing way to set a fixed dollar amount to purchase a particular investment on a regular, recurring schedule over time. By gradually investing slowly, bit by bit, you lower the risk of losing too much money if the market drops, and benefiting when the market is looking up.
But there are critics who maintain that DCA and 401(k)s don’t mix -- that contributions to a 401(k) are an example of investing money as you receive it, at the mercy of market fluctuations. To truly harness the benefits of a dollar-cost averaging structure, experts say that you would ideally instruct your plan manager or administrator to take each 401(k) contribution and invest it manually to the better performing investments at that given moment. That would not only take up time and effort, but works against the defined contribution structure of a 401(k).
Too few investment options
Personal finance expert and Mad Money host Jim Cramer is a long-held critic of the lack of investment options for 401(k) account holders. He’s not happy with the limited selection for investors to choose from -- mostly a few stocks and bond funds.
While IRAs or other retirement accounts provide ample investment choices, 401(k)s may often fall short of giving you the choices you want. Ideally, a complete and comprehensive retirement package should hold several asset class categories. But the fewer investment options you may have available to you can make for a portfolio unable to grow more than what it deserves.
Vexing tax problems
401(k)s allow you to make contributions from your pre-tax, gross income; your funds are only taxed upon withdrawal. Part of the potential problem with 401(k)s is how that money is taxed.
Withdrawals from your 401(k) are taxed at the same rate as your income taxes, which experts contend could prove disadvantageous to you. Ideally, any interest you’ve accrued and dividends you’ve built over the years of investing in your account should be taxed at the capital gains tax level to minimize losses to your assets. But since they’re taxed as income, that means more money taken out upon withdrawals, lessening the value of your account and offsetting your earnings.
Don’t let some of those possible drawbacks prompt you to retire your retirement account before you’ve actually retired. (That would trigger some unwanted penalty fees.) If you’re looking for an alternative or supplement to your existing 401(k), or a primary retirement savings account if your employer offers none, try some of these ideas:
- Brokerage account: You won’t get the tax deferral benefits of a 401(k) or IRA with a brokerage account, but it’s a good alternative to put away some post-tax dollars. There are several types of brokerage accounts to choose from -- everything from stocks, bonds, mutual funds, and even certificates of deposit or money market accounts.
- A myRA: A myRA (that’s "My R.A." versus "I.R.A.") is new to the investment scene, a U.S. Treasury Department creation allowing you a maximum balance of $15,000 (or lower, for up to 30 years). Once you reach that limit, your funds are transferred/rolled over into a private Roth IRA for continued growth. But beware of low returns, estimated between 2 and 3 percent, which may not grow enough to outpace inflation rates.
- Annuities: In a nutshell, an annuity is an investment savings product through an insurance company. Investing in one or more annuities is a tax-deferred chance to grow your retirement fund through a variety of interest rates (fixed, variable or indexed). Just invest with caution: annuities can carry high fees and penalty charges, and investment performance is backed only by the ability of the insurance company to pay the claims they receive.
- Use your tax refund: If you decide to open an IRA, or a savings account, or just want to put some money under your mattress for retirement, reserving your annual income tax refund is a good place to start. Rather than spend the money, use it to jump start your fund and invest it in your preferred savings method. To guarantee it goes to the right place, filling out tax form 8888 arranges to have your funds directly deposited into one of several interest-bearing deposit accounts.
Image: American Advisors Group