Contributing to your 401(k) is one of the easiest ways to save for retirement. Many employers automatically enroll new workers in their 401(k) plans, and investing is as simple as diverting a portion of each paycheck to your retirement fund.
However, the 401(k) isn't perfect, and it does have its disadvantages. If you're relying only on that to save for retirement, it could be costing you without you even realizing it.
While every type of account will have its drawbacks, there are a few downsides to the 401(k) that are particularly costly.
The types of investments available to you through your 401(k) are determined by your employer and plan administrator. Most 401(k) plans offer participants a handful of mutual funds to choose from.
This isn't necessarily a bad thing, but it makes it almost impossible to customize your portfolio through a 401(k). By comparison, IRAs allow investors to choose from countless different options, including stocks, bonds, mutual funds, index funds, and ETFs.
The more options you have to choose from, the better your portfolio will fit your individual needs. If you're only investing in a 401(k), you may have to settle for investments that aren't quite right for you.
Most 401(k) plans offer mutual funds as their primary investment option, and these actively managed funds can be expensive.
Unlike passively managed investments such as index funds, actively managed mutual funds have a manager choosing stocks to be included in the fund. That results in higher fees than passively managed funds.
Because you have limited investment options with a 401(k), you might have no choice but to invest in mutual funds with higher fees. The average 401(k) participants pay fees of around 1% of their total investments, according to research from the Center for American Progress. So if you have $500,000 in your 401(k), you'd pay $5,000 per year in fees alone.
The 401(k) is an employer-sponsored retirement account, so it's tied to your job. This means that if you leave your employer, you'll need to figure out what to do with your 401(k).
You can cash out your investments, but that will result in hefty penalties and taxes. If you find a new job that offers a 401(k), you can roll the money from your old 401(k) into your new one. Or you can simply leave the money in your old 401(k), but you won't be able to make any additional contributions.
If you switch jobs frequently, managing your 401(k) can be a major hassle. In some cases, it may be easier to invest in an IRA instead because these accounts are tied to a brokerage, not your employer. So no matter what happens with your employment, you can continue investing in the same account.
Contributing to your 401(k) can be a fantastic way to prepare for retirement, but it has its downsides. While there's no harm in investing in one, it might be wise to consider contributing to other types of accounts, too. By choosing your retirement accounts carefully, you can make the most of your savings.