3 Reasons Your 401(k) Is Not Enough for Retirement

A 401(k) plan allows employees to make salary-reduction contributions on a post-tax and/or pretax basis. Employers that offer a 401(k) can make non-elective or matching contributions to the plan. They also have the option to add a profit-sharing feature to the plan. All earnings to the 401(k) plan accrue on a tax-deferred basis.

Typically, caps are placed on 401(k) contributions. Internal Revenue Service (IRS) regulations limit the allowed percentage of salary contributions. There are restrictions on the ways in which employees are able to withdraw these assets, and there are restrictions in terms of when they are allowed to do so without incurring a tax penalty.

Here's why, even if you save the maximum, your 401(k) is probably not enough for retirement.

1. Inflation and Taxes

The cost of living increases constantly. Most individuals underestimate the effects of inflation over long periods of time. 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 lifestyles and may still struggle financially to make ends meet.

Taxes are also an issue. The benefit of 401(k)s is that they are tax-deferred. It also means that the 401(k) will grow without accruing taxes. However, upon withdrawal, distributions will be add to the retiree's yearly income and will be taxed at his/her current income tax rate. The rate will, like inflation, probably be higher than individuals may have anticipated 20 years beforehand. The nest eggs that individuals have been building in 401(k)s for 20 or 30 years may not be as bountiful as they might have expected.

2. Fees and Compounding Costs

The effect on 401(k)s, and associated mutual funds, of administrative fees can be severe. These costs can swallow more than half of an individual's savings. A 401(k) typically has more than a dozen fees that are undisclosed, such as trustee fees, bookkeeping fees, finder's fees or legal fees. How to Know if Your 401(k) Plan Fees Are Too High gives some details.

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, it leaves the individual with 5%. It sounds like the individual receives the greater amount, but, the magic of the fund business makes part of an individual's profits vanish. This is 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 an individual retires, a mutual fund may have taken up to two-thirds of his gains.

3. Lack of Liquidity

The money goes into a 401(k) is essentially locked in a safe that cannot be opened until an individual reaches a certain age. It is subject to penalties and fees if there is an early withdrawal. The fund lacks liquidity. An individual cannot invest or spend money to cushion his 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 the 401(k) under certain circumstances, with the burden of being obligated to pay it back within a certain period of time. If the individual loses his job or his income, the deal changes for the worse, requiring him to fully repay the balance of the loan within 60 days. See When a 401(k) Hardship Withdrawal Makes Sense and 8 Reasons to Never Borrow from Your 401(k)

The Bottom Line

Since a 401(k) may not be sufficient for an individual’s retirement, it is important to build in other provisions for retirement, such as making separate, regular contributions to a traditional or Roth individual retirement account (IRA). For more ideas on what to do, see I Maxed Out My 401(k)! Now What?