Reasons Your 401(k) Is Not Enough for Retirement

You may need other sources of income

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 and 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.

For 2023, the maximum contribution is $22,500. If you're 50 or over, you can add a $7,500 catch-up contribution to that amount for a total of $30,000 in 2023. For tax year 2022, the maximum contribution to a 401(k) was $20,500, with a catch-up contribution of $6,500, for a total of $27,000.

Employers can help by making elective contributions (as well as matches), regardless of how much an employee contributes, but there are limits. In 2023, the limit on total contributions to a 401(k) from any source is $66,000. This is an increase from $61,000 in 2022. Plus, 401(k) participants can't have annual additions greater than 100% of their annual compensation.

Given these characteristics of 401(k)s, yours is probably not enough for retirement even if you save the maximum amount, and we share three big reasons why.

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.

Try to invest in low-cost index funds or ETFs. 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.

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 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.

401(k) account holders will not receive the entire portion of their account value, as when the money is withdrawn, they will have to pay taxes on it due to it being a tax-deferred account. The amount of tax paid will relate to the account holder's tax bracket at the time of withdrawal.

Fees and Compounding Costs

The effect of administrative fees on 401(k)s and associated mutual funds can be severe, and these costs reduce 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) took a 0.36% fee on average in 2021. If a fund is up 7% for the year but takes a 1% fee, for example, you're left with 6%. It sounds like you're getting the more significant amount but by the time you retire, a mutual fund may have taken a significant portion of your gains, especially considering the lost opportunity of long-term compounding.

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.

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. 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.

How Much Does a Person Need in a 401(k) to Retire?

This all depends on what type of lifestyle you expect in retirement and what other retirement income or assets you have. If you need $100,000 per year to live and you can expect an average return of 5% per year from your 401(k) assets, you would need more than $2 million saved up. You also have to take into account the deferred tax liability in your retirement account. So, if you are in the 25% tax bracket in retirement, you would actually need $2.5 million in your 401(k).

What Is a Good Monthly Retirement Income?

This will vary depending on one's particular circumstances, but according to experts, one should expect to have a net income that is roughly 80% of their pre-retirement income.

What Else Can I Draw From in Retirement in Addition to My 401(k)?

In addition to 401(k) withdrawals, you may also have an IRA or Roth IRA from which you can also draw retirement funds. In addition, you will likely receive some amount of Social Security retirement income. Any personal savings or non-retirement investments can also be tapped.

If you own a home and are unlikely to pass it on to your heirs, a reverse mortgage can also provide income in retirement. Finally, retirees are increasingly returning to the job force, taking part-time work to supplement their income.

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.

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. It is recommended, if possible, to have 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. Having a part-time job will also help a person 'ease' out of the workforce rather than simply ending their working career cold turkey.

Article Sources
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