4 Reasons to supplement your 401k
401(k)s and other employer sponsored retirement plans like 457(b) and 403(b), are great and usually very convenient. You should absolutely take advantage of these as much as you can. Some employers offer matching contributions that help supercharge your retirement savings, but even with these benefits it can be a good idea to diversify your retirement savings beyond just your 401(k).
Here are 4 reasons to expand your retirement saving strategies:
Tax diversification
Retirement timing
Limited Investment options
Fees may be higher
1. Tax diversification
In a typical 401(k) your contributions are automatically deducted from your paycheck and the primary benefit (other than saving for your future) is that these contributions lower your taxable income. Great, less taxes are nice. Of course you know Uncle Sam is going to get their cut at some point. Naturally, when you take distributions from your 401(k) in retirement, this is when Uncle Sam will start collecting and you will pay regular income tax.
The key item to consider here is that you can never know for sure if you will pay more or less taxes in retirement. Part of it will be based on whether you expect to make more or less in retirement and the other part is more political. Will there be changes to how income and retirement is taxed? Good luck with your guesses, you won’t know until it happens. Under our current progressive tax system, your marginal tax rate goes up as you move higher in the tax brackets. It's reasonable to assume that the progressive tax system will likely remain in a similar format for the foreseeable future.
Early on in your career it’s likely that your earnings will be at the lower end of your income range and towards the middle or end of your career, your earnings will be at their highest. So early in your career it is reasonable to assume that your income in retirement may be higher and vice versa when you compare your retirement income to the end of your career.
Ultimately what you are aiming for is to minimize your tax liabilities as much as possible and a traditional 401(k) does not always give you that flexibility. Pre tax contributions can be great, but it is nice to have options. For example, a Roth IRA is an option that allows you to put after tax money in and pull it out tax free in retirement. The contribution limits are much lower (about $6k) than a 401(k) and there are also income limits ($140k for individuals) where you can no longer contribute to a Roth IRA.
It's worth noting that Roth 401(k)s are becoming more available in employer retirement plans. If available, I recommend using both a traditional pre tax 401(k) and an after tax Roth 401(k). Having both awards you the flexibility to choose how you save for retirement. Early in your career when your taxes are lower, it might make more sense for you to contribute more heavily to your Roth 401(k) or Roth IRA. Later in your career, when your taxes are likely higher it might make more sense to contribute to your traditional 401(k) where you can take more advantage of the tax savings.
A quick example of how one might allocate between a traditional and Roth 401(k):
Let’s assume you are saving a healthy 20% of your paycheck towards your retirement. Great job, you’re well on your way to a successful retirement.
Early in your career you may contribute 15% to your Roth 401(k) and 5% to the traditional 401(k). Since traditional 401(k) tax reduction may not be as beneficial.
As you progress through your career, you may transition your contributions to 5% Roth 401(k) and 15% traditional 401(k) by the end of your career when the tax relief will have a larger impact.
The bottom line is take advantage of all your options to minimize your taxes.
2. Retirement timing
Typically you can’t withdraw from your 401(k) until you are at least 59 ½ years old unless you are willing to pay a 10% penalty. Of course with almost everything in life, there are some exceptions to the 10% penalty, like large amounts of unreimbursed medical expenses or becoming permanently disabled. So it’s safe to assume that under normal circumstances you will pay a 10% penalty in addition to any taxes you may owe if you withdraw from your 401(k) early.
How should you plan if you want to retire early? Or maybe a partial retirement in your 40’s or 50’s? Here are a couple popular options that will give you more timing flexibility:
Roth IRA
One more shout out to the Roth IRA. One of the perks to a Roth IRA is that you can withdraw contributions at any time tax and penalty free. For example, let's say you have contributed $10k to your Roth IRA over the last ten years. And let’s say that account has grown to $20k over the last decade. You would be able to pull out up to the $10k you contributed without any taxes or penalties. Here is more info on Roth IRA withdrawal rules.
Taxable brokerage accounts
Another option is a standard brokerage account like Robinhood, M1 Finance, Fidelity, Charles Schwab and TD Ameritrade etc. Unlike a retirement account, a taxable brokerage account won’t have the same tax advantages. Any dividends or earnings you realize will be taxed. The trade off here is that you can withdraw your money any time you like, without worrying about any penalties. Taxable brokerage accounts are great saving and investing vehicles for your longer term financial goals where you need more flexibility.
3. Limited investment options
Employer offered retirement plans are provided through 401(k) vendors, which means you won’t have much ability to change and that you will be limited to whatever investments they offer. For example, the 401(k) vendor that my employer uses has about 35 different mutual funds to choose from, several target date funds, funds that cover various industries and market caps. It’s likely that you would have access to common index funds that cover the basics of what normal investors would want.
The limitations really come into play for those that are looking for more control or more unique investment exposures
4. Fees may be higher
Since you are limited to what your employer provides, you also get stuck with whatever fees the plan administrator has. I do recommend going through your investment options and seeing what the various fees are. You may find that there are several funds that invest in similar indexes, but one may have much lower fees than another. 1% fees may not seem like much, but over many years this will chip away at your overall returns. Do your research and make sure you are minimizing the fees wherever possible.
Final Thoughts
Overall the 401(k) and its equivalents are great ways to save tax advantaged money and you should take advantage of them if you have the opportunity. That being said, they are not your only option. Taxable brokerage accounts, Traditional and Roth IRAs are also helpful tools to help you save for retirement and other longer term investment goals. These tools can give you extra flexibility and save you money over the long term. Do your research to see how you can level up your retirement game.
This post was adapted from an article written by the Motley Fool
