Why You Don't Want To Rely Solely On Your 401(k) For Retirement And How To Diversify

What if I told you that your million-dollar 401(k) might not be your ticket to a dream retirement? Don’t believe me? Let me explain.

The 401(k) And Its Purpose

A 401(k) is a defined contribution employer sponsored retirement plan which you can contribute to for retirement. It was created as an alternative to the traditional defined benefit pension plans many companies used to have.

In many pension plans, you work for X amount of years and get a defined income for life.

In a 401(k) plan, you contribute a defined amount each paycheck and get a lump sum of many to draw income from until it runs out.

In the past, pension plans plus Social Security would be enough for most people’s retirement so they wouldn’t need to save in addition to it.

This was a blessing and a curse. Today, many take the same attitude with 401(k)s but they shouldn’t.

How A 401(k) Works

A Traditional 401(k) is where you contribute pre-tax dollars. They have the opportunity to grow tax-deferred by investing in stocks or bonds. Then at age 59.5 or older, you can withdraw those dollars but must pay ordinary income tax on the full amount you withdraw.

Additionally, your employer may match contributions up to a certain percentage of your income. This is also contributed on a pre-tax basis and is fully taxed at ordinary income tax rates upon distribution at age 59.5 or older.

The Risks Of Relying On Your 401(k)

1. Market Risk: The money in your 401(k) will be invested in stocks and bonds. Because of this, you have a risk of loss due to markets decreasing.

2. Liquidity Risk: If you need to access your money in the 401(k) before 59.5 years old, you may not be able to without penalties besides the circumstances outlined here.

3. Longevity Risk: If you live too long, your money could run out.

4. Tax risk: If taxes are higher in the future, your money could be worth less than you anticipated.

1 Million Dollars Isn’t Enough

Because of the 3 risks above, you need to be careful with how much you withdraw each year from your 401(k) in retirement.

If you had $1,000,000 at age 65 and expected to live off of it for the rest of your life, the math says you can only take $33,000 per year according to Morningstar.

This means if you make $100,000 per year, you’ll need $3,000,000 at 65 to maintain the same standard of living!

Diversifying To Supplement Your 401(k)

I don’t have a crystal ball. I can’t tell you where taxes will be in the future. So just like you diversify your investments, you’ll want to diversify where you hold your investments.

3 alternatives that hedge the risks of a traditional 401(k):

1. Roth IRA Or Roth 401(k)

After-tax dollars go in. They have the opportunity to grow tax-deferred. Your contributions are accessible penalty-free at any time, but your earnings will not be accessible without penalty until 59.5 years old.

When they are distributed at 59.5 or older, your contributions come back to you non-taxed and any earnings may be distributed tax-free. This will hedge tax risk.

2. Taxable Investment Account

After-tax dollars go in. They are taxed any time to sell out of a position or receive a dividend. These dollars are accessible penalty-free at any time.

If you held the investment for less than 1 year and 1 day, you are taxed at ordinary income tax rates, but if you held for 1 year and 1 day or longer, you are taxed at preferential long-term capital gains tax rates. This will hedge liquidity risk.

3. Real Estate

Real estate is typically not correlated to the stock market (though it can be). It also provides a stream of income via rental income. In addition to this, you have the potential of appreciation of the property. This helps hedge longevity risk and potentially market risk.

Lasting Thoughts

It's clear that putting all your hopes in the 401(k) basket could be a risky move. A healthy plan calls for a more diversified approach. Your 401(k) is a huge part of your retirement savings, but it isn't a standalone solution. It needs to be complemented with other investment vehicles to hedge against various types of risks. Remember, it's not about rejecting the 401(k); it's about using it with other strategies to create a balanced retirement plan.

Disclaimer

This article is meant to provide general information and does not constitute financial advice. Everyone's financial situation and retirement goals are unique. Therefore, it's important to consult with a certified financial planner or another trusted financial professional who understands your individual circumstances before making any decisions based on the information in this article. Tax laws are complex and subject to change, which can materially impact investment results. Always consider your personal investment horizons and risk tolerance levels before making investment decisions. Past performance is no guarantee of future results.