The 401(k) is the most important retirement savings tool for most American households, but many people are hurting themselves by making a handful of common mistakes without even knowing it. Luckily, most of them are easy to fix. Consider these four common missteps and the ways to correct them.
1. Ignoring tax liability
People love the tax deductions created by 401(k) contributions. Those deductions can be enormously helpful as you build a retirement fund, but the IRS gets its cut eventually. Your 401(k) grows on a tax-deferred basis over the decades, but you'll have to pay up when you access that cash.
Image source: Getty Images.
Distributions from qualified retirement accounts are taxed as ordinary income. That means you almost certainly won't realize the full value of your 401(k) or traditional IRA. Many people are shocked when they learn their retirement account is functionally 10% to 20% lower than the balance shows.
There's nothing wrong with a tax deferral -- it is still hugely beneficial. Many people fall into lower tax brackets during retirement, so they'll happily incur those taxes after their working years. Just don't get caught off guard when it's time to make withdrawals. Educate yourself on tax rates and your expected sources of income in retirement. You never want to learn the hard way that your budget needs to be tighter than anticipated.
2. Losing out on the employer match
This one is really straightforward, and it's important to take full advantage of it. Most employers offer to fully or partially match employee contributions to their 401(k), up to a certain percentage of income. One of the best ways to increase your savings rate and meet your retirement goals is to contribute the entire amount that's eligible for employer matching. The employer match is basically free money, and it will grow over time as it's invested. Obviously, it isn't wise to stretch yourself too thin or build debt to achieve this goal, but most people can comfortably earmark an additional 1% to 2% of their income for this purpose.
Ask your plan advisor or employer about the matching policy that's available to you and to confirm you are getting the right amount deducted from each paycheck.
3. Misallocating your portfolio
It's important to get your investment allocation right, and plenty of people fail to keep up as their circumstances evolve. Target-date funds have done wonders for the passive investing crowd, because they'll automatically adjust your portfolio over time. Those are great, but not everyone uses them, and they aren't necessarily tailored to your individual risk tolerance.
For most people, their 401(k) plan advisor can provide useful tools upon enrollment. These resources help you to review goals, assess risk tolerance, and develop an investment time horizon to quantify the best balance between growth and volatility. This will provide guidelines for how your savings should be spread among stocks, bonds, and other assets.
Most people don't review their retirement accounts annually. That's fine for a while, but it will eventually create problems. Your ideal portfolio composition changes over time, and it's important to stay on top of that. It's generally best to prioritize growth early on, but volatility management becomes more important as you get closer to retirement. That means heavy portfolio weighting toward stocks with a rotation toward bonds as people move into their 50s and 60s. Many people don't invest aggressively enough in their early years. Others fail to protect their gains and expose themselves to untimely losses during critical years before retirement.
Getting the balance wrong can really crush your long-term performance and prevent you from enjoying the best possible retirement.
4. Losing perspective on timing
This ties into the larger point on allocation, but it's really about managing your emotions and expectations.
Too many people in their 30s check their retirement account balances weekly or monthly -- or in some extreme cases, daily. That's not only a waste of time, but it could lead to destructive behavior that can undermine your long-term goals.
Your 401(k) is not meant to be accessed until your 60s. It can come in handy for financial hardships or the purchase of your first home, but it's not optimized for those uses. You should plan to keep 401(k) assets tucked away for decades.
If you have 15 or more years until you retire, then it doesn't really matter how your 401(k) performed over the past year. Those gains or losses are only imaginary until you lock them in. The only things that really matter are that dollars continue to flow in and that you're invested for long-term growth (in line with your risk tolerance, of course). Fear can motivate people to sell at the worst times, and that's certainly a challenge for retirement savers in 2022.
For a diversified 401(k), bear markets are only a temporary diversion. As the global economy grows, corporate profits will rise, and that propels stock prices higher in the long term. Don't let today's bad news distract you from the overall plan. Excessive tinkering or selling today isn't likely to pay off over the long term. Keep yourself calm during temporary rough patches.
