Seven Common 401k Mistakes
A 401k may be one of the best ways to save and invest in your future − if you know how to use it. A 401k offers immediate tax savings and tax deferral. It may also offer matching contributions from your employer and access to professional money management. Keep in mind, however, that any withdrawals will be taxed as ordinary income, and may be subject to a 10% penalty if you take them before you’re 59.5 years old.
Sadly, most people commit at least one (if not multiple) easily avoidable 401k mistakes. Here are the some of the most common mistakes people make − and some useful tips to avoid them.
1. Not participating
Thirty percent of those eligible don’t contribute to their 401k plans.1 Are you one of them? You could be missing out on an effective pretax and tax-deferred way to invest. And, many employers match their employees’ contributions, so you could also be passing up on free money (subject to your plan’s limits and vesting schedules). What are you waiting for?
Get started with small contributions. Worried that you can’t afford it? You might be surprised about how little it takes since contributions are made on a pretax basis. Participating may have less of an impact on your take-home pay than putting money into a traditional savings account. For example, if you make $30,000 a year and contribute 3% a year to a 401k plan, your biweekly paycheck would be reduced by only $26, rather than the $34 it would take to save 3% on an after-tax basis. This is based on a 25% tax bracket.
2. Missing out on the employer match
More than 20% of 401k participants don’t contribute enough money to get all the matching money their company offers.2 If you aren’t getting the full match from your company, you’re not only missing out on the company match, but also potential growth from that money.
Take a look at the difference when a fictitious 401k participant, Steve, increases his contributions and gets the full company match.
(starting at age 30)
|4% Contributions||6% Contributions|
|Annual salary (paid bi-weekly)||30,000||30,000|
|Employer match||50% on the first 6%||50% on the first 6%|
|Balance at age 65||$257,772||$386,658|
This is a hypothetical example, and is not intended to predict or project the results of any investment. Returns may vary over time. Fees and taxes are not reflected in this example, and would lower the totals shown.
Gradually increase your contributions so you contribute enough to get the maximum amount your company matches. The money is taken directly from your paycheck, so it’s like paying yourself first. Try to make small increases each year, for example when you receive a raise or bonus.
3. No planned savings goal
Without a plan, you run the risk of not having enough to support your current lifestyle once you retire. Or, you may even outlive your retirement assets. To have the retirement of your dreams, take time to understand your retirement goals and develop a plan to achieve them.
Create a plan. Even if you already contribute to a 401k, you might not be contributing enough or choosing the right investment categories to achieve your goals. Consider taking these steps:
- Use the Closing Your Retirement Gap (PDF) action plan to find out how much you need to save
- Meet with an investment professional to evaluate your current financial situation, discuss your retirement goals and develop a plan
4. Poor diversification
Ever heard of asset allocation? That simply means looking at your age, risk tolerance and goals to determine the mixture of stocks, bonds and cash for your portfolio. Asset allocation can help you diminish investment risk, but keep in mind that you may need to re balance your portfolio periodically in response to changing needs and investment performance. Keep in mind, asset allocation doesn’t assure a profit and doesn’t protect against loss.
Work with an investment professional to develop an asset allocation strategy based on your retirement goals. You can ensure that your portfolio stays diversified by signing up for automatic re balancing.
5. Chasing performance
Some investors make the mistake of chasing investments in the latest “hot” sector. This is a race they’re bound to lose. If you’re thinking of joining the chase, remember that research shows that asset allocation determines more than 90% of the long-term return of a portfolio.4
Keep looking at the long term. Your best defense against market ups and downs is to follow an asset allocation strategy. Review your portfolio at least once a year to make sure it matches your investment objectives and to determine if you need to make adjustments.
6. Taking a loan from your 401k plan
Taking a loan for an emergency or first home is understandable. But, when you take a loan from your 401k you run the risk of reducing the amount of money you have at retirement. It could cost you.
Consider this before taking a loan:
- Participants who take loans contribute less, on average, to their 401k plans than participants who don’t have loans1
- If you don’t repay the loans, you can incur penalties and taxes
- While the loan money is out of your account, it isn’t bringing market returns
- The loan may be costly depending on your exposure to the market and how well the market performs during the loan period
Check with your employer to see if you have to repay the loan in full when you leave the company. If so, plan on staying with your current employer until it’s repaid.
Keep contributing while repaying the loan. If you reduce or stop contributing to your 401k plan while repaying a loan, your retirement assets may be severely affected.
Here’s how the numbers work for Karen, a 35-year-old with a $30,000 account balance. She takes out an $8,200 loan and discontinues her $2,000 annual deferrals during the five-year repayment period. At age 65, if she had continued contributing, her account balance would be $417,289. Since she stopped, her balance is $354,866 — $62,423 less (assuming an annual effective return of 7%).
This is hypothetical and is not intended to predict or project the results of any investment. Returns may vary over time. Fees and taxes are not reflected in this example and can lower the totals.
7. Cashing in before retirement
Many people cash out their 401k account balances when they change jobs. It’s not worth it. This can cause the money to lose its tax-deferred status and subject it to income taxes and a possible early withdrawal penalty — all of which means having less money for retirement.
Evaluate your options. You usually have three options for maintaining your retirement assets when you leave your current employer:
- Keep your old account (provided your account balance meets the plan’s minimum balance) and start a new 401k account with your new employer
- Roll your 401k assets over into your new employer’s plan
- Roll your old 401k into an individual retirement account (IRA) and open a new 401k account with your new employer
Not a deposit • Not FDIC or NCUSIF insured • Not guaranteed by the institution • Not insured by any federal government agency • May lose value
1Research Highlights: How Well Are Employees Saving and
Investing in 401k Plans 2005 Universe, Benchmark Highlights, Hewitt
2Survey Highlights: Trends and Experiences in 401k Plans 2005, Hewitt (June 2005).
3Taking a chance on behavioral finance, Investopedia.com, Ben McClure (Nov. 25, 2002).
4Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance, Ibbotson and Kaplan, Financial Analysts, Journal, (Jan./Feb. 2000); Brinson Hood Beebower Study (1991).