Are you saving for a comfortable retirement? You can help ensure your quality of life in retirement doesn’t drop, as long as you don’t make a bunch of avoidable 401(k) mistakes.
To be fair, not everyone has access to a 401(k). Some folks have other plans, like 403(b)s, and they can pretty much follow this advice too. Others are still lucky enough to have a guaranteed pension, and may not need it. And some folks work for themselves or for employers who have no plan at all. Fortunately, there are retirement plans even if you don’t have one through an employer.
But for those who have employer-sponsored retirement plans, there’s no easier way to put a nest egg aside for retirement. And you need one. While Social Security will likely still be around for most of us in some form, it’s likely to be reduced in the future. Even now, it rarely provides enough for a comfortable retirement.
So most of us need to save for retirement if we want to be able to live in something like the manner to which we’ve become accustomed, only with more free time and less stress. And 401(k)s are a great way to bulk up retirement savings. They’re automatic, making savings easy. They’re usually tax-deferred (meaning you don’t pay tax on the money now, only when they’re withdrawn).
Now just don’t screw up your golden opportunity.
The first 401(k) mistake that screws up your comfortable retirement is the biggest one.
15% of eligible employees choose not to participate in their company’s plan. That means 15% walk away from their opportunity to save for their future, even when an employer plan is offered. Some are even walking away from the employer match that is essentially FREE MONEY (more about that later.)
These non-contributors may have pretty good reasons. Maybe they think they don’t make enough to free up anything for retirment. Okay, are you going to make enough when you retire? Probably not. Much easier to save now while you are actually earning.
Maybe they think they think the enrollment paperwork is too much trouble.The enrollment paperwork rarely takes more than an hour or so to fill out, and you can probably get someone to help you do it if you need it.
Maybe they don’t like or understand the investment options. Okay, just pick the one you dislike the least or understand the most. Just pick something. Investment options change, and you can always educate yourself more and change your investments later.
The most important 401(k) decision to make to ensure a comfortable retirement is to sign up for your company’s plan as soon as you can and get started.
Not Getting the Full Match
If someone said, “Here’s some Free Money!,” would you take it?
Sure, and yet, every year, people turn down free money from their employers when they don’t take advantage of their employer match.
While not every company offers a 401(k) match, plenty offer one. Usualy, the match says something like “For every dollar you put into the plan, the company will add 50 cents, until the total match equals 3% of your gross pay.” Some companies will even offer dollar-to-dollar matches, and some offer higher or lower percentages.
And yes, some companies put conditions on their part of the contribution, commonly saying you have to work for the company for a certain length of time in order to keep the match. But even if you don’t plan to stay at a company all that long, it’s still worth getting the match. Who knows? You could stick around a lot longer than you think.
If your employer offers a match, make sure you take full advantage. It’s the best way of leveraging your own money to get better returns. There aren’t too many investments that guaranty 50 cents on the dollar annually.
Only Getting the Full Match
Okay, now you’re participating, and you’re getting the full employer match. But is 5% of your salary (or 7 1/2% after the match) going to get you the retirement of your dreams?
Probably not, particularly as you get older.
Look, if you have a bunch of debt to pay down and you limit yourself to the match while you aggressively pay down your debt, then you have a good argument for only contributing enough to get the match. But most folks are going to need to contribute more than that. Maybe not the full $18,500 annually that the government allows, but probably more than 7 1/2%.
The easiest way to ramp up your contributions is to put part of every raise toward your 401(k). Even assuming a 2% raise, adding 1% each year can really add up over time without making you feel like you’re being deprived.
That said, the comments below prompt me to admit that you can ramp up your retirement savings outside your 401(k) instead, especially if your employer plan options don’t seem attractive. IRAs, whether Roth or traditional, offer more investment options and may be a better second savings option after maxing the employer match. Just remember that unlike your 401(k) contributions, you may not be able to deduct your IRA contributions at higher income levels.
Keeping Your 401(k) in Cash
There are a lot of risk-averse folks out there, and some of them really don’t like the stock market. So they contribute to their 401(k) to save for the future and get that free money from their employer, but then they don’t invest it. They keep it all in nice, safe cash.
And that’s a big 401(k) mistake.
Cash REALLY isn’t all that safe, because the piddly interest rate you get paid on your cash is way lower than the rate of inflation.
Yes, the stock market can go down, and returns on the investments in a 401(K) aren’t guaranteed. Companies go bust, and their stock becomes worthless.
Fortunately, mutual funds make up most 401(k) plans. They are much broader than a single stock.Over time, the stock market bounces back. As long as you keep your money in the market and don’t sell when the markets crash, so does your account balance. If you keep investing during the crash, you’ll have bought stocks when they’re cheaper and be better off long term BECAUSE of the crash.
Just don’t sell.
If your low risk tolerance keeps you wary, or if you feel too close to retirement to play the market, you can at least move your money out of cash and into bonds for safety’s sake.
Not Paying Attention to Fees
Not all 401(k) plans are created equal, and not all investments in them are good. Sometimes, there can be some real stinkers.
Paying big fees to the mutual funds in your retirement holdings means your retirement savings don’t work as hard as they should. If you invest $100 a month for 10 years (assuming a 4% return), the difference between a 1% and a .2% fee is over $575. Over 30 years, it’s over $8000.
Maybe your 401(k) doesn’t offer Vanguard Index funds, but you should still be able to find a fund that won’t cost too much.
Not Understanding All of the Plan
When employers set up their retirement plans, they don’t necessarily set up the same rules.
Don’t assume you understand all the rules. Read the plan documents.
Some plans will let you take out loans, some won’t (and I’ll explain in a minute why you shouldn’t take one.) Some plans let you keep your money in their plan indefinitely, Others will force you to cash out upon leaving your job, especially if your balance is low.
Your employer may set up a plan with automatic enrollments, or not. The plan may have Roth options. It may have different rules for rollovers or for beneficiaries.
Know your plan. Make sure it does what you think it does, or you may end up with some inconvenient surprises later.
Getting a Loan
A 401(k) loan sounds like a great idea, right? You borrow from your 401(k) for a new home or some other really noble reason, then pay yourself interest as you pay it back.
In theory, it can be, if you pay the loan back on time. But it comes with some caveats.
The first is that even if you pay back the loan, you lose the investment potential of the money you’ve pulled out. Maybe you’ve used the money well enough to mitigate that, or maybe not.
The second, more serious problem, is that if you leave your job, you have to pay the loan back in full immediately, or the loan becomes a distribution. Even if you go on unpaid leave, you may have to keep making payments while you’re on leave, depending on the terms of the loan.
If the loan becomes a distribution, it becomes income. You have to pay income tax on it. And unless you’re older, you probably have to pay the 10% penalty on early withdrawals. And unlike other early distributions, you haven’t done any withholdings to offset the income tax.
This can all leave you with a big tax bill and a lower retirement account balance. Ouch.
Cashing Out When You Leave Your Job
So, you’ve left your job, and your old company’s HR department might want to know what you want to do with your 401(k). Or maybe you have some bills to pay, and you know you have money stashed in your retirement account. They can just send you a check, right?
Don’t do it.
Unless you’re over age 55, you’ll pay a 10% penalty on any distributions you take when you leave your job, and regardless of your age, you’ll pay income tax on the distribution.
If you cash out a big 401(k), it can bump you into new tax brackets. Even a small one can move you into new territory. If you really need the money because you have no other options, at least consider taking only what you need rather than the full amount.
If you don’t NEED the money, then don’t cash it out. It’s meant for retirement, and you should save it for retirement. Leave it be, move it over to your new employer’s plan, or roll it directly into an IRA. Whichever you choose, you’ll avoid paying extra taxes and still have your retirement funds waiting to see you through retirement.
Don’t Wreck Your Retirement
So if you want a comfortable retirement (and most of us do), take advantage of whatever retirement plans your employer makes available. Just avoid these common 401(k) mistakes, and dream of a future that makes you smile.
What have I missed? Any other 401(k) traps to avoid?
*Part of Financially Savvy Saturdays on brokeGIRLrich.*