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Don’t Let Your 401(k) Go Solo – Your Retirement Needs Backup Investments

Consider other types of accounts to complement your 401(k) and provide a diverse foundation to a retirement plan.

By Sam Dixon

With traditional pensions going the way of rotary phones and CD players, 401(k) plans are now the main vehicle many Americans ride into retirement. Nearly 60 million American workers are active 401(k) participants.

Sam Dixon

Sam Dixon

But are people relying on them too heavily? For some, 401(k)s are their only source of saving and investing toward retirement.

They are certainly nice to have when building savings tax-deferred during the working years. Along with the tax benefits, consistent 401(k) employee contributions on each paycheck, coupled with matching contributions from employers and long-term asset growth, combine to build a solid nest egg. But if that is the only egg in your retirement basket, you may regret it.

Why? Relying on solely the 401(k) means a negative tax impact when one taps into it in retirement. It also limits savers from other potentially fruitful investment opportunities, and it impedes liquidity. Therefore, it helps to consider other types of accounts to complement the 401(k), providing a diverse foundation to a retirement plan.

Mitigate the tax risk. The tax advantages one receives while building a 401(k) retirement fund are certainly worth it. With contributions made pre-tax, the funds grow on a tax-deferred basis.

But remember, when you withdraw money from a defined-contribution plan, you have to pay income taxes on it. The money will be taxed at your income tax rate at the time you withdraw the money. And chances are, given the 2025 expiration of the tax cuts enacted in the 2017 Tax Cuts And Jobs Act, plus the exploding federal budget deficits, tax rates will go back up in the near future when many are in their retirement years.

Many people think, or have been told, that they will be in a lower tax bracket in retirement, but that’s not always true. Desiring to maintain the same standard of living they had in their prime working years, people require close to the same amount of income, and that means having the same or perhaps a higher tax rate.

So to mitigate this tax risk, investors can opt for saving in a Roth IRA. Roth withdrawals in retirement are tax-free (taxes are paid at the time of earning). This type of IRA also allows one to grow money tax-free. In exchange for these benefits, the saver contributes money to it on an after-tax basis.

But there is added flexibility with a Roth. For one, you can use the contributions for qualified expenses, such as college expenses, without a penalty. For another, the account can be passed on to heirs.

Don’t restrict liquidity. Remember, too, that 401(k) funds can be used only in retirement. There’s a stiff penalty for early withdrawal – it’s subject to income taxes plus a 10% penalty.

Emergencies and financial opportunities invariably come up well before retirement, and having liquid funds, such as brokerage accounts, can come in handy. Let’s say you need money for an investment property or to start a business, and all you have is your 401(k). It won’t be worth it to tap into it, due to the penalty you’ll pay.

At the same time, it’s not wise to be stashing away as much as possible in a 401(k) while having high-interest debt on credit cards. Pay down the debt, then contribute more to your 401(k).

Give yourself more investment choices. With a 401(k), employees have little control over the fees or investment choices in the plan. A wider range of options is available in an IRA from reputable brokerages. A traditional IRA allows a wage earner to save money in an account that allows the money to grow tax-free. Contributions to the account can be deducted from your taxable income, and though you’ll pay taxes when you withdraw the money in retirement, one has flexibility in investment choices. A Roth IRA also gives one a bigger landscape of selections that appreciate substantially over the years.

Having a company-sponsored 401(k) plan is a great benefit from an employer, but it’s wise to add some support around it. One thing to consider with any account is that you’ll pay taxes either now or later. The 401(k) can work well for you, but it’s a risk to let it work solo. Alternative accounts add more flexibility and control.

About the author: Samuel J. Dixon, RFC

Samuel J. Dixon, RFC, is a managing partner at Oxford Advisory Group. A graduate of the College of Business at Florida State University, he specializes in retirement planning, estate planning, and investments for retirees, executives, and small business owners. He lectures on risk aversion in retirement and developing a predictable retirement plan.