401(k) Plan vs. Stock-Picking: What's the Difference?

Investing in a 401(k) plan may be frustrating to people who like to pick their own stocks. The available offerings through an employer can be limited. And, of course, there are restrictions on that 401(k). The biggest is that you can't touch the money until you're just shy of 60 without incurring a penalty, with a few exceptions.

But there are significant advantages to a 401(k) plan that must be considered by anyone who is thinking about going solo on retirement investing. The tax benefits are substantial. In addition, almost half of employers match some portion of their employees' contributions to a 401(k). It’s hard to say no to free money.

The 401(k) sometimes gets a bad rap. Financial gurus complain that it’s a poor replacement for a pension plan and that there may be better options for investing your money. But is investing on your own one of those better options? Let’s compare the two.

The 401(k) Plan

First, a 401(k) comes with tax advantages. One option is the Roth 401(k), where you pay income taxes on your contributions up front, and then withdraw the money tax-free in retirement.

For a non-Roth account, the money invested is subtracted from pre-tax earnings. Delaying taxes until the money is withdrawn—or, to use the government lingo, until distributions are made—keeps more money invested in your account during your working years, and that equals greater earnings over time. 

But with every advantage comes a tradeoff. You can’t touch 401(k) money until you reach age 59½ without paying the income tax due plus a 10% tax penalty. (There are certain exceptions, such as disability.)

Your investment options are limited to the choices your employer offers. These generally include a wide enough range of mutual funds, from very conservative to very aggressive funds, to satisfy most investors. Your employer may even offer a self-directed option where you can manage all or a portion of your funds on your own.

Finally, no one can predict what the tax rate will be when you retire. That makes it difficult to estimate just how much money you'll have to retire on. (A Roth account avoids this issue.)

Stock-Picking

Many of us have major financial goals that aren't related to retirement: A down payment on a house or a college education, for instance.

That makes investing on your own seem like an attractive option. The money in your account is available at any time for any purpose. There are no 10% penalties, and you don’t have to meet any requirements for withdrawal.

You also get the freedom to invest in anything you want. But that doesn't make it the better choice. For starters, there’s no company match for the money you invest on your own.

The tax advantages of a 401(k) plan combined with an employer match are a winning combination.

“If you invest your retirement directly into stocks instead of a retirement account, you will be subject to taxes on the dividends and capital gains when you sell the stocks. You also have the variability of stock price performance that may require you to sell at an inopportune time. While you may want to buy and hold, the economic outlook may change, requiring you to sell and realize capital gains,” explains Kirk Chisholm, a wealth manager at Innovative Advisory Group in Lexington, Mass.

There’s also the matter of your skill as an investor. Making significant money over time as a stock-picker is extremely difficult. Even the pros have trouble outperforming the overall market. That's why index funds are so popular.

The Bottom Line

For most people, the 401(k) is the better choice, even if the available investment options are less than ideal. For best results, you might stick with index funds that have low management fees.

If you have money to invest above the amount that is matched by your employer or you don’t have employer-sponsored accounts, then these can be times when investing on your own can be more advantageous.