A good 401(k) is the cornerstone of any long-term retirement savings plan. 401(k) plans offer tax benefits, automatic savings features and potentially free money in the form of an employer match. However, there are drawbacks to investing in a 401(k). Some are particular to 401(k) plans in general, while others are specific to individual plans. You might already be familiar with some of the more obvious drawbacks, but others may have escaped your attention, so take a look at 25 potential negatives to your 401(k) plan that will help you to better understand and optimize it.
Last updated: Oct. 21, 2019
For all of the publicity surrounding how great it is to invest in a 401(k) plan, the investments themselves are often shrouded in mystery. You typically set up automatic investments through your employer, allocate your money across various funds and the rest takes care of itself. If your investments cost you anything, you don’t usually feel it since the process is so automated.
However, behind the scenes, your 401(k) plan is taking a cut. As an investor, you’ll pay the expense ratio on various funds, but your employer is likely to face additional costs from the 401(k) provider itself. These costs range from administrative fees and revenue-sharing fees to consulting and advisory fees. All of these costs reduce the total return provided for employees.
Limited Asset Classes
When you buy investments in an IRA or a regular taxable account, you can usually invest in almost anything you’d like. Stocks, bonds, mutual funds, ETFs, CDs, gold and commodities are freely available. You might even be able to invest in cryptocurrencies, emerging market bonds, options or master limited partnerships. In a 401(k), however, you’re limited to select asset classes as delineated by your plan. In many cases, you’ll only have access to the most basic choices, such as large-cap stocks, small-cap stocks, investment-grade bonds and Treasury securities. This can be a major drawback since 401(k) plans often comprise the bulk of an investor’s retirement savings.
Limited Fund Options
In addition to having limited asset classes to invest in, many 401(k) plans also limit the investment choices you have within those asset classes. For example, your 401(k) might offer large-cap, small-cap and foreign-stock buckets, but only one mutual fund option for each. If you want exposure to that asset class you’ll be forced to choose the available fund — even if it has high expenses and low performance. This is one of the major weaknesses of 401(k) plans in general. While they encourage retirement savings — which is a definite plus — you have practically no investment freedom.
Plans Can Change at Employer's Whim
When you’re an employee, you can choose which funds you want to allocate your 401(k) to but you essentially have no power regarding the administration of the plan itself. That’s because a 401(k) plan is employer-sponsored, meaning you can only participate in one if your employer offers it.
If your employer wants to change providers, drop or add different funds, eliminate loan provisions or otherwise tinker with the specifics of the plan, you have no say in the matter. You might wake up one day to find that your all-time favorite mutual fund, which held the bulk of your 401(k) assets, is no longer part of your plan.
Loans Can Become Instantly Payable
Not all 401(k) plans have a loan provision, and you should avoid raiding your 401(k) funds, anyway. Even so, it’s still nice to have such a provision built into your plan should an emergency need arise. In most cases, you can borrow up to 50% of your 401(k) value and pay back both principal and interest to your own account within five years or less. But here’s the catch: If you leave your employer for any reason, your plan sponsor might require you to pay back the loan immediately. If you don’t, the amount of the loan might be reported as a taxable distribution. This can cause a serious cash flow problem right when you’re switching jobs — or, even worse, while you’re in between jobs.
Fund Performance May Be Poor
Although you might get lucky and find some star performers in your 401(k) lineup, far too many plans feature generic funds that are used to plug asset allocation slots rather than provide outstanding long-term performance. If you need a large-cap fund in your lineup and all you get is an average performer, you’re simply out of luck. You can pile more money into the best-performing fund in the lineup, but then you’ll likely be out of balance when it comes to asset allocation.
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Recordkeeping May Be Poor
A 401(k) plan is a notoriously complex instrument. Employers must comply with numerous federal regulations in setting up the plan and they might have hundreds or even thousands of employee accounts to establish and maintain. Although many 401(k) providers have streamlined the process, many others struggle with recordkeeping. You might not get the type of complete and thorough information regarding your 401(k) account that you’re accustomed to with other investments or bank accounts.
The rise of online banking has brought with it a wave of innovation. Boring, clunky websites are now the outlier rather than the norm, as sleek interfaces aim to make banking easy and even fun. Mobile apps have added an enormous level of convenience, as you can now do anything from deposit a check to pay a bill right from your phone. If you’re looking for all of these high-tech features in your 401(k), however, you’re likely to be disappointed. Although there are exceptions — some plans now allow app access — many 401(k) plans only let you access your account through an employer website. In most cases, you won’t be able to make or change your contributions or perform other banking functions through a mobile app, either.
Hidden Brokerage Costs
Many 401(k) participants view their plans as no-cost, and it’s easy to see why. Employers withhold money from paychecks and deposit it directly into 401(k) accounts, and all of the money seemingly goes to work. One factor that’s missing in the equation is that mutual funds in a 401(k), just like mutual funds outside of a 401(k), have expense ratios. These funds cost money to run, so expenses must be deducted from the returns of the funds. This isn’t anything nefarious, or even anything different than funds outside of retirement plans. But participants still need to be aware of them.
Ordinary Income Taxation
One of the biggest drawbacks to a 401(k) plan is related to taxes — even though tax advantages are often cited as among the biggest benefits of a 401(k). It’s true that you can make pretax contributions that grow tax-deferred within the account. But the problem lies when you actually withdraw your money. Everything that comes out of a 401(k) plan is taxed as ordinary income unless it is rolled over into another qualifying plan within a certain amount of time. This is true even if the bulk of your profits have come from capital gains, which is often the case in a 401(k) plan. If you are in one of the higher tax brackets, this means you might end up paying much more than the current capital gains tax rate of 15% when you take money out of your account in the form of a distribution.
Nothing says illiquidity like a 401(k) plan. Can you sell any of your funds at any time? Sure, in most cases. Can you swap money between the funds in your plan whenever you want? Almost certainly. So, how is a 401(k) illiquid? Well, if you want access to your money without fear of penalty — as in, taking it out so you can carry it in your pocket — you’re out of luck unless you’re at least 59 1/2, suffer hardship or leave your job.
Imagine you’re 20 years old and just starting your first job. This means you might not see the money in your 401(k) for about 40 years. While this is great if you’re trying to build long-term wealth, it’s incredibly restrictive when it comes to liquidity.
Limited Early Withdrawal Options
If you really, really need to take money out of your 401(k) account, you have limited options. With few exceptions, IRS rules forbid 401(k) distributions unless you reach age 59 1/2, your plan is terminated or you become disabled. You might also be eligible if you are fired from or otherwise leave your job, or if you have a financial hardship. From the perspective of the IRS, financial hardships that are voluntarily incurred or reasonably foreseeable do not qualify. In most cases, even if you can access your money early, you’ll owe not just ordinary income tax on the entire amount but also a 10% early withdrawal penalty. For some participants, this could amount to nearly half their entire distribution.
May Affect Social Security Taxation
When it comes time to begin taking 401(k) distributions, you’ll have to report those withdrawals as ordinary income. By definition, these distributions will raise your total income and might bump you up into a higher tax bracket. If you’re living solely on your Social Security benefits, they are likely 100% tax-free. However, if your 401(k) distributions push you into the middle-income or higher-income categories, up to 85% of your Social Security benefits may become taxable.
Mandatory Distributions at 70 1/2
No matter how much you like your 401(k), at some point, you’ll be required to start taking money out of it. Even if you continue to work at your job, once you reach age 70 1/2 you can no longer make contributions and, in fact, will have to start taking withdrawals. The amount you’ll have to withdraw every year is based on your account balance and your life expectancy. The IRS uses the Uniform Lifetime Table to determine life expectancy. Divide your year-end account balance by your life expectancy in the table and you’ll see the amount you’re required to withdraw. Note that this number will change annually.
Negative Tax Consequences for Surviving Spouse
If your retirement plan for your spouse is to leave a huge 401(k) behind, be aware of the tax consequences. Assuming you no longer have dependent children at the end of your life, your surviving spouse will have to change their filing status from “married filing jointly” to “single.” This means the 401(k) withdrawals your surviving spouse takes will likely be taxed at a higher rate — in some cases, much higher.
For example, as of 2019, if you earn $205,000 as a couple — including your 401(k) distributions — you’re taxed at a 24% rate. If you’re single, that rate jumps to 35%. Even on smaller amounts, the jump can be dramatic. If you’re earning $40,000 as a couple you’re in the 12% bracket, but if you’re single, you’ll pay 22%.
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Tax Laws May Change
One of the benefits of a 401(k) plan is that it encourages saving for the long haul. Unfortunately, over a time period of 20, 30, 40 or even 50 years, it’s next to impossible to predict how tax laws will change. The Tax Cuts and Jobs Act of 2017 lowered personal income tax rates across the board, but the next Congress — or the one after that, or the one after that — might turn around and raise taxes to all-time highs. This means that contributions made today might get hit hard when it comes time to make a withdrawal. Imagine you’re in the 12% tax bracket today. A $10,000 contribution will generate $1,200 in tax savings. However, if tax rates rise to 25% by the time you retire, you’ll owe $2,500 in taxes on that same contribution.
Purchases Are Made at Regular Intervals
One of the advantages of a 401(k) plan — convenience — is also one of its drawbacks. When you contribute to a 401(k), money is taken out of your paycheck at the same time every month. While it’s nice that you don’t have to put any effort into making contributions (or even think that much about them), it also means you can’t take advantage of large market swings and opportunistically contribute funds at the best possible times. Over the long run your contributions should theoretically average out, but you can’t move your capital in the midst of a market sell-off like you could in a regular taxable account or IRA.
There May Be Fees If You Change Jobs (or You May Be Kicked Out of Your Plan)
If you switch jobs, keeping your 401(k) plan might become an issue. In some cases your employer might kick you out of the plan, forcing you to either take it to your new employer or roll it over into an IRA. Other employers might allow you to maintain your 401(k) account, but for a fee. Either way, it’s not likely to be business as usual with your 401(k) plan. Even if you keep your plan at your ex-employer, you won’t be able to make tax-advantaged contributions because you won’t be earning a paycheck there any longer.
Company Matches May Shrink
Another great benefit of a 401(k) plan is that your company can match a portion of your contributions. For example, if you contribute 6% of your salary, your company might match half of that. The potential problem is that your employer match can be changed or reduced at any time. If the company falls on hard times, the employer match could be one of the areas that get cut.
You'll Probably Have To Manage Your Own Investments
When you sign up for your 401(k) plan you’ll probably receive written information about investments and might be given a representative to help you understand how the plan works. However, if you want real help planning your retirement, you’ll probably have to work with your own financial advisor or do things yourself. A 401(k) plan is, for the most part, a self-managed investment plan. You’ll have access to information about your account through your employer’s 401(k) website, but you’ll have to pull the trigger yourself when it comes to allocating your investments.
Your Investments Are Not FDIC-Insured
If things go wrong in your 401(k), don’t expect the Federal Deposit Insurance Corp. to step in. The vast majority of 401(k) investments are not FDIC-insured, with the possible exception of certain bank products. Your mutual fund buckets — including stocks, bonds, precious metals and international securities — are subject to market fluctuations like any other investment. Just because the plan is offered by your employer and promoted as a long-term retirement plan doesn’t mean it’s backed by the kind of insurance that protects bank accounts.
You May Have To Wait To Participate
If you’re signing on with a new employer specifically because of its great 401(k) plan, you might be in for a surprise if you expect to take part immediately. Many employers don’t offer a 401(k) plan to employees until the open enrollment period, or until a certain period of time has passed, which might be as long as one year. In the meantime, if you want to contribute to a tax-advantaged retirement account you’ll likely have to stick with an IRA and its contribution limit. As of 2019, that limit was a paltry $6,000 for those younger than 50.
You Might Not Become the Millionaire You Think You Will
In theory, a 401(k) is an easy path to becoming a millionaire. Between the tax advantages granted to contributions and the relatively high contribution cap, workers who contribute regularly and start young enough can easily reach the $1 million threshold through prudent investing. The problem is that reality is not keeping up with the dream. As of 2019, the average 401(k) balance was $103,700, according to Fidelity. Although that’s a sizeable amount, it’s a far cry from the $1 million or more many financial planners say you’ll need to live a reasonably comfortable retirement.
Other Options May Be More Attractive
There’s no doubt that 401(k) plans have many benefits, but at the end of the day, you might do just as well — or even better — with a different type of account. The limited investment options in a 401(k) plan might be the biggest culprit, as most don’t allow investments in some of the more speculative areas of the market. Most 401(k) plans also don’t let you invest in individual stocks. While financial advisors don’t usually suggest that you put the bulk of your money into a single stock, a diversified portfolio of hand-picked, high-growth stocks might give you the type of return that you just can’t achieve in your 401(k) plan.
You Might Not Ever See Your Money
This is obviously a worst-case scenario, but it’s always possible that you pass away before you have the chance to enjoy the money you’ve invested in your 401(k). Since most 401(k) plans restrict your withdrawals until age 59 1/2, a premature death means your money has been tied up for your entire life without providing you with any real benefit. A disheartening scenario, to be sure — and one that’s highly unlikely for the vast majority of Americans — but it is a potential drawback.
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About the Author
After earning a B.A. in English with a Specialization in Business from UCLA, John Csiszar worked in the financial services industry as a registered representative for 18 years. Along the way, Csiszar earned both Certified Financial Planner and Registered Investment Adviser designations, in addition to being licensed as a life agent, while working for both a major Wall Street wirehouse and for his own investment advisory firm. During his time as an advisor, Csiszar managed over $100 million in client assets while providing individualized investment plans for hundreds of clients.