A 401(k) plan allows employees to make salary-reduction contributions on a pretax basis (and also on a post-tax basis in some cases). 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. The maximum contribution limit to a 401(k) in 2019 is $19,000, up from $18,500 in 2018. For someone who makes more than $150,000 per year, that means contributing the 401(k) max will give them a savings rate of 12.67%. The more someone makes above $150,000, the smaller their contribution percentage will be. 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, Calif. [Note that if you're 50 and over, you can add a $6,000 catchup contribution to that figure, for a total of $25,000 as of 2019.]
For 2019, the limit on contributions to a 401(k) from any source is $56,000, up from $55,000 in 2018. Individuals age 50 or older can contribute an extra $6,000 via a catch-up contribution. All 401(k) contributions must be made no later than Dec. 31.
There are also 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, once a retiree starts withdrawing savings, those distributions will be added to the retiree's yearly income and will be taxed at their 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. Accordingly, many savers will seek out ways to save above and beyond their 401(k) plan.
"All dollars are tax deferred, which means that for every $1 you save today, you will only have about 65 to 80 cents based on your tax bracket. For our higher income earners, this is an even more serious issue as they are in higher tax brackets. A $1 million balance isn't really $1 million for you to spend in retirement," says Marguerita Cheng, CFP®, RICP®, chief executive officer of Blue Ocean Global Wealth in Gaithersburg, Md.
"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," says David S. Hunter, CFP®, president of Horizons Wealth Management, Inc., in Asheville, N.C.
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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. It's easy to become overwhelmed when 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, 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 you retire, a mutual fund may have taken up to two-thirds of your gains.
3. Lack of Liquidity
The money goes into a 401(k) is essentially locked in a safe that can only be opened until an individual reaches a certain age or when they have good reason to suffer the penalties and taxes of an early withdrawal. In short, 401(k) funds lacks 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 The Wealth Coach for Women, Inc., in Rockland, Mass. "If you withdraw funds prior to age 59½, 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, it is possible you could bump yourself to a higher tax bracket, adding to the cost."
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 you lose your job or income, the deal changes for the worse, requiring you to fully repay the balance of the loan within 60 days.
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 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 will not 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 within the area of tax planning," says Carol Berger, CFP®, of Berger Wealth Management in Peachtree City, Ga.
"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 7Twelve Portfolio, in Springville, Utah. "Plus, having a part-time job will help a person 'ease' out of the workforce rather than simply ending their working career cold turkey."