The Uncomfortable Truth About 401(k)s

The Uncomfortable Truth About 401(k)s (0:00)

Bo: The 401(k) is the most common retirement account in the country, and if you have one, you should likely be using it. But there are some details about 401(k)s that people often leave out, and some misconceptions that can cost you big time. Today we’re going to cover five uncomfortable truths about 401(k)s that most people aren’t talking about, so that you can get the most out of yours.

Uncomfortable Truth #1: A 401(k) Alone May Not Be Enough (0:31)

Bo: One of the mistakes people often make with 401(k)s is treating it like a complete retirement strategy instead of one piece of a bigger picture. If you retire with everything in a traditional 401(k), every single dollar you pull out in retirement is going to be taxable income. And if you’ve been a diligent saver for 30 or 40 years, you could be sitting on a pretty massive balance, which sounds like a great problem to have until you hit RMD age. The IRS forces you to start taking money out whether you need it or not. If your traditional 401(k) grows large enough, those forced withdrawals, also known as required minimum distributions, can push you into a higher tax bracket, spike your Medicare premiums, and create a tax bomb that you never saw coming.

Bo: That’s why the first uncomfortable truth is that your 401(k) alone is probably not enough. Now, don’t mishear me. A 401(k) is a great account to have, but adding other account types to the mix can give you flexibility that can really help you from a tax perspective. When it comes to saving for retirement, there are three buckets that you generally want to fill. Your tax-free bucket, which would be your Roth accounts and HSAs. Your tax-deferred bucket, which is your traditional 401(k), your IRAs, or other employer-sponsored plans. And then your after-tax bucket, which would be things like a taxable brokerage account or a trust account. The goal is to have money in all three buckets so that in retirement you can draw from different accounts depending on your tax situation each year. A 401(k) fills that tax-deferred bucket really well, but don’t leave the other two empty.

Uncomfortable Truth #2: Having a 401(k) Doesn’t Build Wealth — Contributing Does (2:10)

Bo: Uncomfortable truth number two: having a 401(k) doesn’t build wealth. Contributing to it does. This one might seem obvious, but the data tells a far different story. According to Vanguard’s How America Saves report, the median Vanguard defined contribution plan participant deferred just 6.8% of their income in 2024. That’s well below what it needs to be for a comfortable retirement. Our benchmark is 25% of your gross income saved and invested across all of your accounts. We know that sounds like a stretch for a lot of people, but we’ve done the math. If you’re investing 25% of your gross income by age 30, you will likely be able to replace 80% of your pre-retirement income by age 60. So it’s a target that actually puts you on track for financial independence.

Bo: But here’s the thing — depending on how old you are, you might not actually need to save exactly 25%. If you want to know how much you should save based on your age and your goals, check out our free resource, How Much Should You Save? It can help you figure out exactly what you need to be doing to reach your retirement goal.

Uncomfortable Truth #3: Your Roth 401(k) Isn’t Entirely Roth (3:23)

Bo: The next uncomfortable truth about 401(k)s might come as a total shock, especially to those of you with a Roth 401(k), because your account might not be what you think it is. If your employer offers a Roth 401(k) and you’ve been taking advantage of it, that’s awesome. But here’s something a lot of people don’t realize. Your Roth 401(k) actually has two separate buckets inside of it. The money you contribute goes in on an after-tax basis, but your employer’s matching contributions have to go in on the pre-tax side into the traditional 401(k) bucket. And that’s the third uncomfortable truth: your Roth 401(k) isn’t entirely Roth.

Bo: So what does that mean for you? It means the employer match portion of your Roth 401(k) will be taxable when you withdraw it in retirement, just like a traditional 401(k). Now, this doesn’t mean you shouldn’t use a Roth 401(k) — you likely should. But you need to keep in mind that not all of your balance is tax-free. This is something to factor into your planning, especially when you’re thinking about managing your tax brackets in retirement.

Uncomfortable Truth #4: Forgotten 401(k)s Are a Bigger Problem Than You Think (4:27)

Bo: The next truth about 401(k)s is more than uncomfortable. It’s actually a little painful. According to the Bureau of Labor Statistics, the average American changes jobs about 12 times over the course of their career. And every time that happens, there’s a 401(k) that needs to be dealt with. The problem is that most people just don’t deal with it. According to one report, there are nearly 32 million forgotten or abandoned 401(k) accounts in the US right now, and those accounts hold about $2.1 trillion in assets. That figure represents close to 25% of all 401(k) assets in the country. Nearly a quarter of all money in all 401(k) plans is just sitting there in accounts that belong to people who moved on and forgot to take their money with them.

Bo: Now, it’s likely that many of these left-behind 401(k)s will eventually be found and consolidated, but there’s also a good chance they missed out on higher returns and incurred higher than necessary fees while they were being neglected. That’s why the next uncomfortable truth is that you have to keep up with your 401(k). When you leave a job, make sure you don’t leave your 401(k) behind. Either roll it into your new employer’s plan, roll it into an IRA where you have full control, or intentionally leave it behind for reasons that you are aware of.

Uncomfortable Truth #5: Fees Matter Way More Than You Think (5:53)

Bo: That brings us to uncomfortable truth number five: fees matter way more than people think. Over a long investing horizon, fees can be a powerful force working against your wealth. Let’s say there are two funds that both track the S&P 500, which historically has had an annual return of around 10%. Fund A is a low-cost index fund with an internal expense ratio of 0.015%, giving it a net return of 9.985%. Fund B is a higher-cost fund with an expense ratio of 0.67%, giving it a net return of 9.33%. While that difference may sound tiny, over time it can be massive. If someone invested $500 per month for 40 years, Fund A would grow to over $3 million, while Fund B would only make it to around $2.5 million. That’s over half a million dollars less in retirement, all because of a fee that was slightly too high.

Bo: And here’s the really uncomfortable part. Most people have no idea what they’re paying because the fees in your 401(k) don’t show up as a separate line item on your statement. They’re likely buried in the fund prospectuses or plan documents that almost nobody reads. They include things like expense ratios, administrative fees, and 12b-1 fees, all of which quietly chip away at your returns year after year. According to industry research, the average 401(k) participant pays about half a percent per year in total plan costs, and participants in smaller plans may pay even more.

Bo: So go take a look at the investment options inside your 401(k) and pay attention to the expense ratios. In most plans, you’ll find a mix of higher-cost actively managed funds, but also lower-cost index funds. In a large majority of cases, you’d likely be better off using the index funds. And if your plan only offers high-cost options, let your human resources department know. Your employer actually has a fiduciary responsibility to offer reasonable investment options, so you may be able to open the door to better options just by starting the conversation.

How to Get the Most Out of Your 401(k) (8:04)

Bo: Look, 401(k)s are genuinely one of the best wealth-building tools available. We’re not here to scare you away from using yours. If your employer offers one, especially with a match, you should likely be taking advantage of it. But taking advantage of it means more than just signing up. It means contributing enough, understanding what you own, sticking with it, keeping an eye on fees, and making it part of your larger three-bucket plan. And as always, keep building towards your great big beautiful tomorrow.