Why a 401(k) Alone Isn't Enough for a Comfortable Retirement

A 401(k) is a tax-advantaged, employer-sponsored retirement account designed to provide a steady income in retirement. It allows for annual contributions with additional limits for those over the age of 50. Since a 401(k) is opened through an employer, these accounts often include matching employer contributions. They also offer the flexibility to roll over the funds when switching jobs. While a 401(k) is a versatile and dependable retirement account, the question still remains – Is a 401(k) enough to retire comfortably?

A 401(k) can provide a substantial foundation for retirement savings, but it may not be sufficient on its own for a comfortable retirement. Consulting a financial advisor can help determine if contributing to a 401(k) is enough for retirement based on your specific situation and lifestyle needs. This article will also explore why a 401(k) alone might not meet all your retirement needs.

Below are some of the reasons why maximizing a 401(k) is not enough to retire comfortably:

1. 401(k)s offer limited annual contributions

While the 401(k) offers significant advantages for retirement savings, its annual contribution limits may be considered a drawback. The Internal Revenue Service (IRS) sets contribution limits for 401(k) plans each year. While these limits are adjusted periodically to account for inflation and changes in purchasing power, they still impose a cap on how much you can contribute annually. For 2024, the contribution limit for individuals under the age of 50 is set at $23,000. Those aged 50 and above benefit from a higher limit, also known as the catch-up contribution provision. This catch-up allows an additional $7,500 in contributions, raising your total contribution amount to $30,500 annually in 2024. Additionally, the combined contribution limit for employee and employer contributions is $69,000.

There are several important restrictions to be aware of when contributing to a 401(k). Firstly, regardless of your financial situation or retirement goals, you cannot exceed the annual contribution limits. Even if you have the financial capacity to contribute more, you are bound by the IRS-imposed caps. This can be particularly challenging for high earners who wish to accelerate their retirement savings. Secondly, there is no provision for carrying forward unused contribution limits. You cannot roll over the unused portion to the following year if you contribute less than the maximum limit in a given year. Each year’s contribution limit is fixed, and any unused capacity is lost. This can be a disadvantage if you experience a year with lower income, as you lose the opportunity to make up for it in the upcoming years. Another critical aspect to consider is that if you have multiple 401(k) plans through different jobs, you will still be able to contribute only up to the total employee contribution amount for the concerned year. So, even if you work multiple jobs or switch between employers within a year, the combined total you can contribute across all your 401(k) plans cannot exceed the IRS limit set for the year. This can severely limit your ability to maximize your retirement savings if you have multiple income sources.

2. 401(k)s offer limited diversification

While 401(k) plans provide several investment options that allow for some degree of portfolio diversification, these options are often not enough to significantly mitigate risk and maximize returns. The investment choices within a 401(k) are typically limited to a select number of funds, which may include target-date funds, stocks, bonds, and other types of investment vehicles. However, these offer a narrow range of diversification and versatility, particularly when compared to other types of investment accounts. A standard 401(k) plan might offer around 10 or more investment funds. While this might seem adequate, it often falls short of providing the level of diversification needed to reduce investment risk effectively. In most cases, these funds may be heavily concentrated in specific sectors or asset classes. This lack of diversity can increase your exposure to market volatility and economic downturns. The concentration of a handful of assets may significantly increase your investment risk, as a downturn in a single sector or asset class could have a considerable impact on your overall portfolio.

If your investments are not adequately diversified, the volatility of the market can lead to substantial losses. This scenario is particularly concerning if such a downturn occurs close to your retirement age, as you may not have sufficient time to recover from the losses. Relying solely on a 401(k) in such situations can jeopardize your financial security in retirement. This is why it is recommended to consider other investment accounts that offer broader diversification opportunities. These might include Roth and traditional Individual Retirement Accounts (IRAs), and more.

3. 401(k)s may charge high fees

The fees associated with 401(k) plans can significantly impact your retirement savings. According to the Center for American Progress, the average annual fee charged by most 401(k) funds is around 1%. However, these fees can vary widely, ranging from 0.5% to 2% or even higher. The specific fees depend on several factors, including the size of an employer’s 401(k) plan, the number of participants in the plan, and the provider offering the plan. Typically, 401(k) fees can be divided into three main categories – plan administration fees, investment fees, and individual service fees. Over time, the cumulative impact of these fees can be substantial and significantly affect your overall returns. For example, paying a 1% fee versus a 0.5% fee might not seem like a huge difference, but over the course of a few decades, this can amount to a significant portion of your retirement savings. The higher the fees, the more they eat into your investment returns and reduce your retirement nest egg. This is why maximizing a 401(k) is not enough to retire, as the associated fees can lower the value of your savings.

As an investor, you are responsible for paying these fees regularly, and there are limited ways to minimize their impact. One strategy is to select investments with lower expense ratios. However, this can be challenging within a 401(k) plan, as the range of investment options is often limited. Moreover, selecting investments based solely on their expense ratios can lead to poor investment choices. While low fees are important, they should not be the sole criterion for choosing an investment. Other factors, such as the asset’s risk profile, past performance, sector and class, etc., should also be considered. In many cases, 401(k) plans might not offer a sufficient variety of low-cost investment options, forcing you to choose higher-fee investments.

4. 401(k)s lack flexibility in withdrawals

One of the significant drawbacks of a 401(k) account is the limited flexibility in withdrawals before retirement, which can have substantial financial implications. The IRS mandates that withdrawals from a 401(k) before the age of 59.5 years are typically subject to penalties. In addition to federal income tax and relevant state income tax, early withdrawals incur a 10% penalty on the withdrawn amount. Some 401(k) plans allow for hardship withdrawals in cases of immediate and severe financial need, such as medical expenses or to pay alimony in the case of divorce, etc. However, the availability and terms of hardship withdrawals may vary among plan administrators. Some plans do not offer this option at all, while others may have strict guidelines and terms in place which make it difficult to withdraw your money. This can leave you with limited recourse in the case of financial emergencies. 401(k)s do offer the option to take on a loan against your retirement savings. While this option can provide you with access to your funds without triggering immediate taxes or penalties, it can come with its own risks. If you leave your current job, you would have to pay the entire outstanding 401(k) loan in full. Failing to repay the loan within the specified timeframe can result in a default, which can lead to a penalty. A defaulted 401(k) loan can trigger income tax on the remaining loan balance, and if you are under 59.5 years old, you would also pay an additional 10% early withdrawal penalty. Therefore, a 401(k) loan may only make sense if you plan to continue working with the same employer for the long term.

Due to these restrictions, relying solely on a 401(k) for financial emergencies can be challenging. In case of any unforeseen circumstances where you need to make a withdrawal, the penalties and taxes can significantly erode your savings. This is why it is important to maintain an emergency fund separate from your 401(k) retirement plan savings. An emergency fund can provide you with immediate access to cash to cover unexpected expenses without jeopardizing your long-term retirement goals. It is advised to maintain an emergency fund with three to six months’ worth of your living expenses to ensure you have a financial safety net in place when times get tough.

In addition to the constraints on withdrawals before retirement, 401(k) plans are subject to Required Minimum Distributions (RMDs) once you reach retirement age. RMDs have been put in place to ensure investors withdraw funds from their retirement accounts, thereby triggering tax that can generate revenue for the government. According to the Secure Act 2.0 passed in December 2022, you are required to start withdrawing from your retirement accounts by April 1 of the year after you turn 73. The minimum value of the RMD is decided on the basis of the IRS Uniform Lifetime Table. Failure to withdraw the mandated amount incurs a hefty penalty. The IRS typically charges a 50% penalty for every dollar not withdrawn.

There are limited scenarios where you may avoid RMD requirements. The first is if you are still working for the company sponsoring your retirement plan beyond the age of 73 and own less than 5% of that company. In this case, you may qualify to defer your RMDs until you retire. However, this option is contingent upon your 401(k) plan’s provisions. Not all plans permit such delays. Another method to sidestep RMDs is by converting your traditional 401(k) to a Roth IRA. Roth IRAs are not subject to RMD rules in your retirement for as long as you live. This is because you have already paid tax on your contributions in your working years. However, it is essential to note that an IRA does not offer contribution limits as high as a 401(k). So, you would lose out on the opportunity to invest as much as a 401(k), which can lower your retirement savings in the future. Moreover, even if you rollover your funds from a 401(k) to an IRA, you would have to pay tax on the converted amount in the year you make the conversion, which can be hard for some people. Therefore, it is advised to choose this option after careful consideration and discussing the pros and cons with a financial advisor.

To conclude

While a 401(k) can be part of your retirement planning, it should not be relied upon as the sole investment vehicle. It can have several drawbacks, such as high fees, pre-fixed contribution limits, limited investment choices, and strict withdrawal regulations. To build a robust retirement strategy, it is essential to invest in other financial tools like IRAs, stocks, bonds, and real estate. Diversifying your portfolio across these assets not only spreads risk but also allows for greater flexibility, lower costs, and the potential for higher returns. Consulting with a financial advisor is essential to understand what investment options work best for you. These professionals can help you select options as per your specific needs and ensure a comprehensive approach to securing your financial future.

Use the free advisor match tool to get matched with seasoned financial advisors who can guide you on what investments to invest in to secure a comfortable retirement. Answer some simple questions about your financial needs and get matched with 2 to 3 advisors who can best fulfill your financial requirements.

To learn more about suitable retirement planning strategies for your unique financial requirements, visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been covered in major business publications such as Barron’s, The Wall Street Journal, and The New York Times as a leader in the investment industry with a track record of creating value for his firm’s clients.