Company-sponsored retirement accounts, including the popular 401(k) plan, have replaced traditional pension plans as the most commonly offered retirement benefit. The cost savings for companies and the preferential tax treatment for employees spurred the popularity of these retirement plans. Now the majority of American corporations offer workers a tax-favored retirement account, sometimes with the company making additional contributions to employee accounts.
But even with company contributions, your 401(k) plan may not be enough. Here is why your 401(k) plan might not completely fund your retirement.
A 401(k) plan is not the same as a pension. Pensions, or defined benefit plans, offer employees a fixed payment, usually for their remaining life span. 401(k) plans reward employees only with the funds the employee or employer contributed while the employee was with the company. Once your 401(k) plan funds are gone, that’s it. It is up to you to take charge of your retirement needs beyond your 401(k) plan.
You aren’t saving enough. Simply saving enough to get your employer’s 401(k) match or even 10 percent of your pay may not be enough to last throughout your retirement. How much you should contribute toward your retirement goal is based on many factors. If you got a late start on your investment plan, then you may need to contribute more than 10 percent of your pay to maintain your current standard of living in retirement.
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You don’t have the proper risk allocation. It’s easy to look at your 401(k) plan as an island unto itself. But it is just a piece of your entire portfolio and should be managed along with your other holdings. Treating your 401(k) plan as a single investment could over or underexpose you to different investment classes, potentially giving you too much or too little risk.
Inflation risks. The cost of living is sure to increase in the coming decades. Your investment portfolio not only needs to keep pace with inflation, but exceed it if you want your investments to last throughout retirement. Compound interest can help your investments grow beyond the risk of inflation.
Taxes. The beauty of the 401(k) plan is that your contributions are tax deferred. Deposits aren’t taxed when you make them and they grow without the drag of taxes until you make withdrawals in retirement. But you have to pay taxes when you take distributions from your 401(k) plan, which means that nest egg you worked so hard to accumulate isn’t quite as bountiful as you think it is.
What you can do to better prepare for retirement. 401(k) plans were never designed to be the sole source of your retirement income. They were designed to give you another source of income in addition to your pension, savings, Social Security benefits, and other sources of retirement income. Opening a Roth IRA is one way you can increase your retirement savings and enjoy the benefits of more flexible investment options and tax diversification. You can also open a trading account with a discount brokerage firm to invest in stocks, ETFs, and mutual funds. It is up to you to look beyond the 401(k) plan and determine which investments you need to fill out your retirement plan.