Access to a 401(k) can be a huge boon to workers saving for retirement, but it's important to remember this account is only a tool. If you want to get the most out of it, you have to learn how it works so you can use it properly. Failure to understand your 401(k) -- or any retirement account for that matter -- can lead to costly mistakes, like the three described below.
1. Skipping a 401(k) match
Whenever possible, make claiming your 401(k) match your top priority. Try to contribute at least enough to the account to get your full match every year. If you don't, you're giving up a bonus that could be worth a few thousand dollars today and possibly tens of thousands or more by the time you're ready to retire.
Check with your company's HR department if you're not sure whether it offers a match or how its matching formula works. Most employers offer a $0.50-on-the-dollar or dollar-for-dollar match match up to a certain percentage of your income. That means that for every dollar you put into your 401(k), your employer will contribute $0.50 to $1.00 on your behalf until you reach the cap. In other words, you can enjoy an instant 50% to 100% return on a portion of your 401(k) contributions.
You should also inquire about your 401(k)'s vesting schedule if you haven't been with the company long. This determines when you're eligible to keep your employer-matched funds if you leave the company. Ideally, you can stick it out until you're fully vested so you don't lose any of your match.
2. Paying high investment fees
All investments charge fees, though not everyone realizes this, because the money comes directly out of your 401(k) each year. There's no way to avoid fees entirely, but you can keep your costs down by choosing your investments carefully.
Most companies offer their employees a choice of various mutual funds, and these have expense ratios, or annual fees expressed as a percentage of your assets. If you're paying a 1% expense ratio, that means you're paying the mutual fund company 1% of all the money you have invested in the fund every year. That's only $1 if you have $100 invested in the fund. But if you have $100,000, you're paying $1,000 per year.
You should try not to exceed a 1% expense ratio whenever possible, but you may not always have a choice. You're limited to the investment options your employer gives you, and these may not always be the most affordable.
If your employer doesn't offer any investment options that suit you, you can talk to them and see if they'll add some more low-cost options such as index funds, but they aren't required to do so.
Your other option is to skip your 401(k) altogether and invest in an IRA, which gives you greater freedom to invest in what you want. But if you go this route, remember to max out any matching 401(k) contributions first. You can then switch to your IRA and even go back to your 401(k) if you max out your IRA for the year.
3. Taking a 401(k) loan
Borrowing from your 401(k) might not be as bad as taking an early withdrawal, but it's still something you should avoid when possible. Doing this will slow the growth of your savings, forcing you to save even more per month going forward in order to retire when you originally planned.
Explore other alternatives before you take money out of your 401(k). If you're looking to purchase a home or car, consider a mortgage or auto loan. You could also look into a personal loan to finance other types of purchases or to help you pay down high-interest debt. Another option is just to wait and save up what you need.
If you do have to borrow from your 401(k), try to withdraw as little as possible. Check with your plan administrator to learn the deadline for repaying the loan and make sure you pay it all back by then. If you fail to do so, the government will consider the outstanding balance a distribution, and you'll pay taxes on it, plus an early withdrawal penalty if you're under 59 1/2.
When thinking about your 401(k), it's crucial to take a long-term view. A decision like skipping a 401(k) match or taking a loan might not seem like a big deal right now, but you'll feel the consequences of these moves more in a few decades than you do right now. Learning about your 401(k) and making decisions with your long-term goals in mind can make your 401(k) one of the best tools in your retirement arsenal.