401(k)s are a popular way for Americans to prepare for retirement, thanks to employer contributions and convenient payroll deductions.
But before you max out your contributions, it's important to understand the potential risks. We'll explore seven factors to consider when deciding how much to invest in your 401(k).
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401(k)s give you less control over your investment portfolio
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Since 401(k)s are employer-sponsored savings plans, the employees don't have much say in deciding what to invest in. Instead, when you sign up for a 401(k) plan, you can only invest in the options offered by your company's retirement plan administrator.
If you want to start investing in a broader range of stocks, bonds, EFTs, and publicly traded companies, you'll need to open an IRA or a traditional brokerage account with a brokerage firm rather than relying solely on your company's 401(k).
You can't do much if your administrative fees are high
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You likely don't have any control over which 401(k) plan administrator your company chooses to work with. As a result, you might end up with a plan that charges higher administrative fees than you'd prefer — but there's not much you can do to change that.
401(k)s aren't practical if you're planning an early retirement
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401(k)s have relatively strict rules governing when you can and can't remove money from the account without paying a penalty. For the most part, if you withdraw funds from your 401(k) before you reach age 59 1/2, you'll pay a 10% tax on the amount you withdraw.
Plus, since 401(k)s are tax-advantaged savings accounts, you'll also need to pay income taxes on the amount you withdraw.
In other words, if you're hoping to retire in your early 50s or sooner, you'll need at least one other account besides a 401(k) if you want easy, penalty-free access to your retirement funds.
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Income taxes can cut into your 401(k) withdrawals
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If you plan to live largely off the money in your 401(k) once you retire, you need to plan for the income taxes you will have to pay on each withdrawal.
For instance, if you withdraw $100,000 from your account, you must report that money as income and pay income taxes according to your income-based tax bracket.
Paying taxes on your 401(k) withdrawals doesn't have to be a financial hardship as long as you plan ahead.
But it's important to remember that the money in your 401(k) isn't entirely yours, and a percentage of it will go to the government instead of landing in your pocket once you're retired.
Income from 401(k) withdrawals might mean your Social Security benefits are taxed
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As long as your income is below $25,000 as an individual or $32,000 as a married couple, the retirement benefits you get in the form of Social Security payments aren't taxable.
However, since you have to report your 401(k) withdrawals as taxable income, your income could exceed that threshold, which means up to 85% of your Social Security benefits become subject to taxes.
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If a recession happens before you retire, you might not have time to recoup your losses
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In 2008, many employees saw their 401(k)s lose well over 20% of their value. While younger employees were able to weather a recession and recoup their losses over the next decade, workers nearing retirement didn't have that luxury.
Adding insult to injury, typical 401(k) advice about making age-appropriate investments fell through during the recession: Investments typically considered stable, including government bonds, lost much of their value as well.
While this type of loss isn't the norm, it's a concern for anyone who relies solely on a 401(k) to fund their future retirement.
Required minimum distributions don't always work in your favor
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Once you turn 72 or 73 (depending on the year in which you retire), you're required to start withdrawing from your 401(k).
You have to withdraw a certain amount of money or face a tax of up to 50% on the amount you failed to withdraw to avoid wasting your retirement savings.
You also owe income taxes on the money you withdraw. If you haven't planned ahead of time to cover the cost of taxes, you could find yourself in a tricky financial bind.
Bottom line
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Having a 401(k) is a part of a solid retirement plan, but it's just one way to help you get ahead financially.
If your current retirement plans hinge on your 401(k), consider meeting with a financial advisor to discuss other savings methods. That way, no matter how the economy trends, when you're ready to retire, you'll have savings to fall back on.
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