A 401(k) account can be one of the most powerful ways to save lots of money for retirement. The tax-advantaged savings account comes with high contribution limits, and you can likely get a bit of extra money from your employer just by contributing to it.
But 401(k) plans can also be fraught with opportunities to make a mistake, killing the potential returns on your savings. Here are six errors to be aware of.
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1. Not maxing the company match
A majority of employers will offer a matching contribution to your 401(k) based on a percentage of your salary. For example, if you make a contribution equal to 6% of your salary, your employer might match that with a contribution equal to one-half of that amount.
It's typically in your best interest to maximize your employer's matching contribution. Not doing so is like foregoing a part of your salary. You won't find a guaranteed return on your investment almost anywhere else besides maxing out the company match on your 401(k).
2. Paying too much in fees
401(k) accounts can come with a lot of fees. If you're not careful, you could easily pay much more in fees than you need to. It's important to be mindful of expense ratios when selecting funds in your 401(k) plan. A good expense ratio for actively-managed mutual funds is typically between 0.5% and 1%, but index funds can get the expense ratio down to a range of just 0.05% to 0.3%.
One area where it's very easy to overpay is when choosing a target-date fund. There are two types of these funds -- one based on active mutual funds and one based on index funds. The latter is much less expensive and more suitable for the goals espoused by target-date fund investing.
If your 401(k) plan doesn't include low-cost index funds and index-fund-based target-date funds, talk to your plan administrator about adding new options to the plan or switching your holdings to investments with lower expenses.
3. Keeping company stock
Some companies pay out their matching contribution to the 401(k) in the form of company stock. And too many people leave that stock as is instead of liquidating it and buying their own investment choices.
Investing in your employer's stock is highly risky. You're already inherently invested in the company since it's your main form of income. Furthermore, keeping company stock could easily result in a portfolio that's unbalanced, creating an even riskier position.
Imagine if the company starts running into trouble, its stock tanks, and it has to lay off workers. In that case, you may be out of a job with a tanking 401(k) balance.
4. Raiding your funds early
The 401(k) offers several ways to access your funds before retirement. You can even take a loan from the account and pay yourself back over time, but your 401(k) balance can't grow if you take money out of the account early.
There are some instances when a 401(k) loan makes sense: for example, if you would otherwise need to use high-interest debt to cover an emergency or if you need a little bit of extra cash for a down payment on a home. But taking an early withdrawal or loan from your 401(k) to pay for your needs today can be one of the most expensive ways to do so when you factor in what those dollars could be worth by the time you retire.
5. Not increasing contributions over time
Some employers will give employees the option to "save more tomorrow." Put another way, the percentage of your salary contributed to your 401(k) will increase every year by a certain amount before it reaches a set threshold. This is a good practice, even if you have to set it up manually at the start of every year.
The system works, because you can barely notice the change in your take-home pay when the percentage change is small enough. The additional contribution is further obfuscated by annual pay raises (if you're lucky enough to get them).
Increasing your contributions every year will set you on a path toward a well-funded retirement without much effort.
6. Not rolling it over
If you leave your job but keep your 401(k) in the same account, you could be making a mistake. After separating from your employer, you have the option to rollover your 401(k) into an IRA. While there are some reasons why you might not want to execute a rollover, most people will benefit.
The biggest benefit of rolling over a 401(k) to an IRA is that you no longer have to pay fees. A 1% cumulative fee in your 401(k) can have a significant impact on your terminal account value when it comes time to retire. Brokerages typically don't charge any fees for IRAs.
The second benefit is IRAs usually have many more investment choices than 401(k)s, which will allow you to make better choices for your investing strategy.
Make the most of your 401(k)
If you avoid these mistakes, you'll be well on your way to a fully funded retirement. And even if you've made mistakes in the past, it's never too late to take action and correct them.
