Top 10 Mistakes to Avoid on Your 401(k)
Most of today’s workers can no longer depend on receiving a pension when they retire. The days of defined-benefit pensions in which the employer guarantees a monthly payment for the rest of the recipient's life are almost gone. Only 22% of workers today have that type of secured pension, according to the Economic Policy Institute.
Instead workers today, if they have an employer-based plan at all, are more likely to have a 401(k) – employees make a defined contribution from their income each year, and there is no guarantee of how much it will amount to by retirement. The amount each employee will have each month at retirement depends on two big factors: how much he or she contributes while working and how the employee manages the money building up in the 401(k). Often, but not always, employers match some percentage of what their employees put aside.
Let’s take a look at 10 of the biggest mistakes you can make when building and managing your 401(k).
Don't Do This
1. Not Calculating Your Retirement Needs
The biggest mistake people make regarding retirement is not taking the time to figure out how much money they will need in retirement. Typically advisors recommend that you plan for an income level of 70% to 90% of your preretirement income.
One of the best tools to help you figure out how much you need to save is the “Ballpark Estimate” developed by the American Savings Education Council and available at the website ChooseToSave.com. Click on the name in the previous sentence for the computer version of this excellent tool, as well as links to apps for iPhone and Android phones.
2. Leaving Money on the Table
If your employer does match your 401(k) contribution, be sure to at least contribute enough to qualify for 100% of that matching contribution. For example, an employer may offer to match 100% of your 401(k) contribution up to 6% of your income. Suppose your income is $40,000: 6% of that is $2,400 or $200 per month. In this scenario you be giving up $2,400 a year of free money if you don’t contribute $2,400 per year to your 401(k) to get that match.
If you're contributing to a traditional 401(k), not a Roth 401(k), your actual out-of-pocket cost won’t be $200 per month because any money you contribute to a 401(k) reduces your taxable income. A salary of $40,000 is in the 25% tax bracket for a single filer. That means your taxable income will be reduced by $2,400 and you would save $600 ($2,400 x 25%) in taxes, so your actual out-of-pocket expense is $1,800 or $150 per month. (By contrast, a Roth 401(k) is funded with after-tax income. Read 401(k) Plans: Roth or Regular? to learn more about which is best for you.)
But whichever you choose – a Roth or a traditional 401(k) – find out how much your employer will match and be sure you don’t leave money on the table by not putting in enough to qualify for the 100% match.
"If your boss called you into his office and offered a tax free raise, what would you say? 'No?'" asks David Rae, a Certified Financial Planner with Trilogy Financial Services in Los Angeles. "Of course, you will say. 'Yes,' and, hopefully, 'Thank you.' When you ignore the company match you are essentially turning down a tax-free raise. It’s free money. No matter what, you need to contribute enough to get the fully company match – this is the bare minimum."
3. Saving at the Default Contribution Level
Some people just accept the default contribution level that their employer chooses. Most employers choose 2% to 3% as their default level. Yet financial advisors typically recommend a combined employer/employee contribution rate of 10% to 15%.
Stephen Utkus, principal and director in the Vanguard Center for Retirement Research, recommends that people with a household income of $50,000 to $100,000 save between 12% and 15% of their income. Workers earning less than $50,000 should try to save 9% to 12%.
If that sounds high to you consider starting at the level of your employer match, then add 1% each time you get a raise. For example, suppose you get a raise of 3%, increase your contribution to your 401(k) by 1% and still get the 2% raise. Continue doing this until you get to the recommended level of savings.
4. Failing to Research Your Investment Options
Be sure you research your investment options. TIAA-CREF in its 2014 Investment Options Survey found that one-third of Americans who participate in a retirement plan are not familiar with their retirement options. The only way you can properly manage your retirement portfolio is to know your options and their investment potential. Reasons 5, 6, and 7 review why this is so important.
This includes researching the fees: "A lot of 401(k)s are loaded with very expensive, actively managed mutual funds that can act as parasites on someone’s retirement nest egg," cautions Mark Hebner, founder and president of Index Fund Advisors, Inc. in Irvine, Calif. "The power of compounding doesn’t only apply to returns, but also to costs. There are also the costs associated with the plan overall. Although there is usually a committee that handles the specific arrangements of the 401(k), employees should feel comfortable providing input about the overall costs of the plan and whether there are index-based investment options."
5. Missing Out on Free Investment Advice Offered
Employers today are required to offer you free investment advice for your 401(k). Usually employers will set up several opportunities for employees to meet with an investment advisor during the year or provide you with a toll-free number to get this advice by phone. You are not required to follow this advice, but you can ask questions and get the information you need to make intelligent investment decisions.
TIAA-CREF found that 62% of people who took advantage of their personalized advice saved more and adjusted their portfolio to improve their allocation of funds.
6. Avoiding Risk Completely
Many investors who are not confident in their investing ability tend to avoid risk completely – or at least they think they are. They tend to put their money in what they consider safe investments – money market funds, certificates of deposit or other guaranteed savings options. The problem with these choices is that none of the options grow at a rate that is faster than inflation, so you are actually losing money if you choose this option.
Beth McHugh, senior vice president, workplace investing communications at Fidelity Investments, recommends that you subtract your age from 110. The answer you get is the amount of money you should allocate to stocks. For example, if you are 30 years old, then 80% should be in stocks.
7. Failing to Rebalance Your 401(k)
You can’t just pick your 401(k) investments and let the fund ride. It’s important to meet with your free advisor annually and review your portfolio choices and your portfolio’s balance. For example, in a really good year, the risky growth-stock portion of your portfolio may grow exponentially. You want to preserve that growth by rebalancing it to an allocation that will enable you to continue to grow your retirement savings without taking on too much risk.
8. Borrowing From Your 401(k)
Don’t borrow from your 401(k). Many companies do allow you to borrow from your 401(k) at an attractive interest rate. The problem is that if you don’t pay it back, the amount you borrow will become immediately taxable and you will have to pay taxes on the money at your current tax rate plus a 10% penalty if you took it out before age 59½. If you lose your job or change jobs, the amount borrowed will have to be paid back immediately – which most people can’t do after the loss of a job – or it will be considered a cash withdrawal. For details, see Borrowing from Your Retirement Plan.
9. Cashing Out Your 401(k)
Don’t cash out your 401(k) when you change jobs. Unless you are 59½ (there are some exceptions if you are at least 55 years old), you will immediately have to pay taxes at your current tax rate plus a 10% penalty. Even with these stiff costs, Marc Zimmerman, vice president of retirement plan consulting at The Centurion Group in Fort Lauderdale, found that 68% of workers took a lump sum when changing jobs. Only 26% decided on taking the best option – rolling it into an IRA, so they could continue to manage their own retirement portfolio. For directions, see Guide to 401(k) and IRA Rollovers.
10. Abandoning Your 401(k)
When you leave a job, don’t abandon your 401(k). Take it with you by rolling it over into an IRA or into your new 401(k) if the new company allows it. "Leaving your old 401(k)s lying around like dirty socks is just going to get messy," says Eric Dostal, J.D., C.F.P, an advisor at Sontag Advisory in New York City. You are going to have a harder time understanding what your overall portfolio allocation is and you may end up paying higher fees than if you consolidated your savings in one account.
Dana Levit, owner of Paragon Financial Advisors in Newton, Mass., warns that the allocation of your abandoned 401(k) may no longer meet your retirement needs. There is also the possibility that your investment choices may no longer be an option and the funds will be switched to a low-interest earning cash account. Taking your account with you is the best way to maximize your returns and keep your money where you can remember that you have it.
The Bottom Line
The comfort of your retirement rests on how well you fund and manage your 401(k). Don’t leave it to chance. Actively manage your retirement funds. For more information, see 5 Secrets You Didn't Know About 401(k)s and How to Make Maximum Money on Your 401(k).