401(k) plans are wonderful for helping people save and invest money for retirement. For many people, their 401(k) will be the bulk of their retirement income.
To really get the most of your 401(k) and make sure you're putting yourself in a good long-term position, you should try to avoid these three mistakes.
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1. Not contributing your full employer match
One of the best perks of having a 401(k) plan is the potential to receive an employer match on your contributions -- it's essentially an automatic 100% return on your contribution. Whenever you're deciding what percentage of your check to contribute to your 401(k), your bare minimum starting place should be however much your employer will match. Not doing so is basically leaving free money on the table.
If the company match is 3%, your minimum should be 3%; if it's 5%, your minimum should be 5%. Whatever the case, as long as the contribution doesn't take so much from your check that it jeopardizes your livelihood, make your employer match the starting point. If you make $100,000 and your employer will match up to 5%, that's an extra $5,000 each year. If you only contribute 3%, that's $2,000 you left on the table.
2. Only considering target date funds
One of the downsides to 401(k) plans is the limited investment options. Unlike an IRA, which operates similarly to a regular brokerage account, the investment options in a 401(k) are provided to you. One of the most common investments in a 401(k) is target date funds, which are based on your estimated retirement year. As you near retirement, the assets in the fund rebalance to become more conservative.
Target date funds have become more popular recently, with 56% of 401(k) plan participants holding them (up from 19% in 2006). A lot of plans even make it the default enrollment option. The one problem with target date funds, however, is that since they're actively managed, they tend to be one of the most expensive options.
Instead of relying on target date funds, consider replicating the fund using a combination of various cheaper funds, such as those based on market cap. Many target date funds contain other funds, adding to the cost. You can cut out the middleman and often invest in similar funds that the target date fund holds.
For example, if you're in your 30s, your breakdown could look similar to this:
- Large-cap fund: 60%
- International fund: 25%
- Mid-cap fund: 10%
- Small-cap fund: 5%
Of course, different breakdowns will make sense for different people based on their risk tolerance, but this shows how contributing to a few funds can be just as efficient as relying on the more expensive target date funds -- and save you thousands in fees over time.
3. Doing an indirect rollover instead of a direct rollover
If you're ever in a situation where you switch jobs and want to combine your old 401(k) plan with your new plan, you have two options: a direct rollover or indirect rollover. If you decide to do an indirect rollover, your old plan provider will send you the money, and it will be your responsibility to put it into your new plan. The IRS requires that you make the transfer within 60 days of receiving the money, or they'll consider it a withdrawal. In that case, you'll owe income taxes on the amount, and if you're under 59 1/2, you'll face the 10% early withdrawal penalty.
Also, if you do an indirect rollover, your plan provider is always required by law to withhold 20% for tax purposes. If you're rolling over $200,000, they'll have to withhold $40,000. You must also replace the withheld amount when transferring the money for it to count as a full transfer without any taxes being owed. If you don't replace the withheld amount, the $40,000 would be reported as taxes paid.
All of this can be avoided if you choose to do a direct rollover. Some people choose indirect rollovers because they want to use the money within that 60-day rollover period, but for those simply interested in moving the money into their new plan, a direct rollover can save the extra work (and the chance of missing the 60-day window and owing money). With a direct rollover, the plan providers do the work for you.
