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 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, which means more money for employees, and 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, plus 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.

Limitations and Restrictions on 401(k)s

On the downside, caps are placed on 401(k) contributions. IRS regulations limit the allowed percentage of salary contributions. In 2019 the maximum contribution to a 401(k) is $19,000, up from $18,500 in 2018. For someone who makes more than $150,000 per year, contributing the maximum will give them a savings rate of only 12.67%. And the more someone makes above $150,000, the smaller their contribution percentage will be.

The problem is that 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. If you're 50 or over, you can add a $6,000 catch-up contribution to that amount, for a total of $25,000 in 2019, but your money won't have as long to grow.

Employers can make elective contributions, regardless of how much an employee contributes, but there are limits on these too. In 2019, the limit on total 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 when they are allowed to do so without incurring a tax penalty.

Why Your 401(k) May Not Be Enough

Given these basics of 401(k)s, 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 of us 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 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.

"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 our 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," 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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Nashville: How Do I Invest for Retirement?

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, 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) often take a 2% fee right off the top. If a fund is up 7% for the year but takes a 2% fee, you're left with 5%. It sounds like you're getting the greater amount, but the magic of the fund business makes part of your profits vanish 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.

Better options might be to invest in low-cost index funds. Also look at easy-to-use target-date funds, which are finding their way into more and more 401(k) plans; but check fees there, as well.

3. 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 when you 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," 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, you could bump yourself to a higher tax bracket, adding to the cost."

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.

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 of time. If you lose your job or income, the deal changes for the worse, as you have to fully repay the balance of the loan by the next federal tax-filing date, including extensions. 

The Bottom Line

Since a 401(k) may not be sufficient for your retirement, it is important to build in other provisions, 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. I always recommend, if possible, having a taxable account, Roth IRA, and IRA (or 401k). This can really help with 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 the 7Twelve Portfolio, in Springville, Utah. "Having a part-time job will also help a person 'ease' out of the workforce rather than simply ending their working career cold turkey."