The 401(k) gets a bad rap. Financial gurus complain that it’s a pretty poor replacement for the pension plan and that there may be better options for investing your money. Maybe one of those better options is picking and investing in individual stocks. Let’s compare the two.
First, it comes with tax advantages. Any money you invest comes from pretax earnings. Pretax means that Uncle Sam doesn’t take any of it before it’s invested, making your contribution worth roughly 30% more.
Your capital gains are tax-free until you make withdrawals. You know that life-changing 2 cents you made on your bank savings account last month? You have to pay taxes on that money this year. (Brace yourself for that bill.) But when you make money on your 401(k), you don’t pay taxes until you start making withdrawals, or in 401(k) terms, distributions.
Paying taxes at distribution keeps more money in your account, and more money should equal more gains over time. (See also:10 Little Known Ways to Reduce Your 401(k) Taxes.)
Many companies incentivize their employees to contribute to a 401(k) by matching a portion of their contributions. In other words, you get free money to save for retirement. It’s hard to say no to free money.
But with every advantage comes tradeoffs. First, because of those tax advantages, you can’t touch your 401(k) money until you reach age 59½ although certain exceptions exist (for example, if you become ill and are unable to work). If you take a distribution from your 401(k) and don’t qualify for one of the exceptions, you’ll pay income tax plus a 10% IRS penalty. That’s a really bad deal.
Second, the investment options available to you are probably limited. Often, these include mutual funds that may have hefty fees attached to them. “Make sure to ask your plan administrator about the fees on the plan and review your investment options to ensure that the mutual funds allow you to meet your ultimate investment and financial objectives,” says Ryne Bessmer, AIF®, a financial advisor with Karstens Investment Counsel, Inc., in Omaha, Neb.
Some plans are better than others – and your employer may offer a self-directed option where you can manage all or a portion of your funds on your own, which gives you access to a much broader selection of investment options. The self-employed have 401(k) options, too, but we’ll save that for another time.
Finally, the tax rate may be much higher when it’s time to take distributions. If a Roth 401(k) is available to you, consider that option to avoid paying higher taxes later. (For more, see 6 Problems with 401(k) Plans and 401(k) Plans: Roth or Regular?)
Maybe simply investing in stocks is a better option. Stocks give you the freedom to invest in anything you want. If you have a non–tax-advantaged brokerage account, you could invest in stocks but also bonds, options, currency, ETFs, MLPs and more. You can withdraw your money any time you want for any reason. There are no 10% penalties, and you don’t have to meet any requirements.
But that doesn't make them the better choice. First, there’s no company match. Your employer probably won’t give you money to invest in your brokerage account. Second, all of those rules that come with the 401(k) may be pesky and annoying, but the tax advantages are huge. If you invested $2,000 per year and assumed a 7% growth rate over 35 years, your 401(k) could earn about $66,000 more than a brokerage account because of the tax advantages and employer match. It’s hard to pass that up.
“If you invest your retirement directly into stocks instead of a retirement account, you will be subject to taxes on the dividends and capital gains when you sell the stocks. You also have the variability of stock price performance that may require you to sell at an inopportune time. While you may want to buy and hold, the economic outlook may change, requiring you to sell and realize capital gains,” says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass.
There’s also the matter of your skill as an investor. Do you know how to pick winning stocks? Statistics show that making significant money over time as a stock picker is exceedingly difficult. So even if you prefer the freedom of picking stocks, the statistical chances of you making more money than through a 401(k) are slim. Even the pros have trouble outperforming the overall market. That's why index funds are so popular.
The Bottom Line
For most people, the 401(k) is the better first choice for retirement savings. Even if the available investment options are less than ideal, the employee match helps to mitigate that issue. Stick with index funds that have low management fees.
If you reach a contribution limit where your employer no longer matches your funds, you could invest additional funds in an individual IRA or a brokerage account rather than contributing those funds to your 401(k) until you reach the maximum permitted contribution. And if you go beyond that, you'll definitely need to put your additional funds elsewhere. See I Maxed Out My 401(k)! Now What?