A 401(k) plan has many benefits for employees who are saving for retirement. It allows them to make salary-reduction contributions on a pretax basis (and on a post-tax basis in some cases).
Employers that offer a 401(k) can make non-elective or matching contributions to the plan, which means more money for employees. They also have the option to add a profit-sharing feature to the plan. What’s more, all earnings to the 401(k) plan accrue on a tax-deferred basis.
Key Takeaways
- Although 401(k) plans are an excellent way to save, it may not be possible to set aside enough for a comfortable retirement, in part because of IRS limits.
- Inflation, plus taxes on 401(k) distributions, erode the value of your savings.
- Plan fees and mutual fund fees can reduce the positive impact of compound interest on 401(k) accounts. One solution is to invest in low-cost index funds.
- If you have to dip into your 401(k) early, you generally will have to pay a penalty—as well as taxes—on the amount you withdraw.
- You can borrow from your 401(k) but you will need to pay the money back with interest.
Limitations and Restrictions on 401(k)s
On the downside, caps are placed on 401(k) contributions, and IRS regulations limit the allowed percentage of salary contributions. In 2020 and 2021, the maximum contribution to a 401(k) is $19,500. For someone who makes more than $150,000 per year, contributing the maximum will give them a savings rate of only 12.67%. And the more someone makes above $150,000, the smaller their contribution percentage will be.
The problem is that a savings rate of 12% is probably too low to reach a comfortable retirement. “A savings rate below 10% is definitely too low,” says Andrew Marshall of Andrew Marshall Financial, LLC, in Carlsbad, California. If you’re 50 or over, you can add a $6,500 catch-up contribution to that amount, for a total of $26,000 in 2020 and 2021 ($19,500 in 2022), but your money won’t have as long to grow.
Employers can make elective contributions, regardless of how much an employee contributes, but there are limits. In 2022, the limit on total contributions to a 401(k) from any source is $61,000, rising from $58,000 in 2021. All 401(k) contributions must be made no later than Dec. 31.
There are also restrictions on how employees can withdraw these assets and when they can do so without incurring a tax penalty. Given these basics of 401(k)s, your 401(k) is probably not enough for retirement even if you save the maximum amount, and we share three big reasons why.
1. Inflation and Taxes
The cost of living increases constantly. Most of us underestimate the effects of inflation over long periods. Many retirees believe that they have plenty of money for retirement in their 401(k) accounts and that they are financially sound, only to find that they must downgrade their lifestyle and may still struggle financially to make ends meet.
Taxes are also an issue. Granted, 401(k)s are tax-deferred, and they grow without accruing taxes. But once you retire and start making withdrawals from your 401(k), the distributions are added to your yearly income, and they will be taxed at your current income tax rate. Like inflation, that rate may be higher than you anticipated 20 years ago. Or perhaps the nest egg that you have been building in your 401(k) for 20 or 30 years may not be as grand as you might have expected.
Marguerita M. Cheng, CFP®, RICP®, chief executive officer of Blue Ocean Global Wealth in Gaithersburg, Md., put it this way:
All dollars are tax-deferred, which means that for every $1 you save today, you will only have about 63 to 88 cents based on your tax bracket. For our higher-income earners, this is an even more serious issue as they are in the higher tax brackets. A $1 million balance isn’t really $1 million for you to spend in retirement.
David S. Hunter, CFP®, president of Horizons Wealth Management, Inc., in Asheville, N.C., adds: “We tell our clients to plan on 30% of their 401(k) going away. It’s going to end up in Uncle Sam’s hands, so don’t get attached to 100% of that value being yours.”
Better options might be to invest in low-cost index funds. Also, look at easy-to-use target-date funds, which are finding their way into more and more 401(k) plans, but check fees with those as well.
2. Fees and Compounding Costs
The effect of administrative fees on 401(k)s and associated mutual funds can be severe, and these costs can swallow more than half of an individual’s savings. A 401(k) typically has more than a dozen undisclosed fees, such as trustee fees, bookkeeping fees, finder’s fees, and legal fees. It’s easy to feel overwhelmed when you’re trying to figure out whether you are being treated fairly or being fleeced.
This is in addition to any fund fees. Mutual funds within a 401(k) often take a 2% fee right off the top. If a fund is up 7% for the year but takes a 2% fee, you’re left with 5%. It sounds like you’re getting the more significant amount. Still, the magic of the fund business makes part of your profits vanish because 7% compounding would return hundreds of thousands more than a 5% compounding return—the 2% fee taken off the top cuts the return exponentially. By the time you retire, a mutual fund may have taken up to two-thirds of your gains.
3. Lack of Liquidity
The money that goes into a 401(k) is essentially locked in a safe that can only be opened when you reach a certain age or have a qualified exception, such as medical expenses or permanent disability. Otherwise, you will suffer the penalties and taxes of an early withdrawal.
In short, 401(k) funds lack liquidity.
“This is not your emergency fund or the account you plan to use if you are making a major purchase. If you access the money, it is a very expensive withdrawal,” says Therese R. Nicklas, CFP, CMC, of Wealth Coach for Women, Inc., in Rockland, Massachusetts. “If you withdraw funds prior to age 59-1/2, you potentially will incur a 10% penalty on the amount of the withdrawal. All withdrawals from tax-deferred retirement accounts are taxable events at your current tax bracket. Depending on the amount of the withdrawal, you could bump yourself to a higher tax bracket, adding to the cost.”
This means you can’t invest or spend money to cushion your life without a significant amount of difficult negotiation and a large financial hit. The single exception to this is an allowance to borrow a limited amount from your 401(k) under certain circumstances, with the obligation to pay it back within a certain period. If you lose your job or income, the deal changes for the worse, as you have to fully repay the loan balance by the next federal tax filing date, including extensions.
The IRS discourages you from taking money out of your 401(k) by charging a 10% penalty on withdrawals you take prior to age 59½—unless you qualify for an exemption.
The Bottom Line
Since a 401(k) may not be sufficient for your retirement, building in other provisions is essential such as making separate, regular contributions to a traditional or Roth IRA.
Carol Berger, CFP®, of Berger Wealth Management in Peachtree City, Ga., explains:
It’s always a good idea to have more options when you reach the “distribution” phase of your life. If everything is tied up in your pre-tax 401(k), you won’t have any flexibility when it comes to withdrawals. I always recommend, if possible, having a taxable account, Roth IRA, and IRA (or 401k). This can really help with tax planning.
“The reality is that many retirees will need to earn a bit of money during retirement to take the pressure off their retirement accounts,” adds Craig Israelsen, Ph.D., creator of the 7Twelve Portfolio, in Springville, Utah. “Having a part-time job will also help a person ‘ease’ out of the workforce rather than simply ending their working career cold turkey.”
Source: finance.yahoo.com