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Your 401(k) can be an incredibly effective tool for creating the retirement of your dreams -- if you use it correctly. This means contributing money regularly, investing it well, and leaving it alone. On the other hand, there are some mistakes you definitely want to avoid.
Contributing the default contribution could leave you short
Jason Hall: Many employers will now automatically enroll new employees in the company 401(k) plan at a default contribution level. While this is a great start, the reality is, that default contribution amount is probably too low, and could leave you with a lot less money than you need when you retire.
According to a survey conducted by the American Benefits Council, the default contribution rate for more than half of respondents was less than 4% of their salary. If your salary is $50,000, that's only $2,000 per year you're setting aside for retirement. Over 30 years, assuming your salary goes up about 2% per year and you net an 8% average annual rate of return, you'd have saved about $298,000.
That may sound a like a lot, but it would only provide about $993 per month in retirement income. Even if your employer matches 50% of your contributions, your expected retirement income from your 401(k) would only be about $1,487 per month after 30 years.
Here's where even seemingly small amounts can make a huge difference over long periods of time. If you bumped up your contribution to 6% of your pay, your monthly income in retirement would increase almost $500 per month to $1,980 per month. At the same time, your pay today would only go down about $83 per month. That's one heck of a good trade-off:
*Based on increasing contributions from $50,000 salary by 2%. ***Assumes 30 years of contributions. Chart source: Author.
Bottom line: Don't make a huge mistake and assume that the default contribution level for your 401(k) will be enough to have a comfortable retirement. Chances are it's not close to enough and you need to increase your contributions today.
Don't borrow from your nest egg
Matt Frankel: One popular 401(k) mistake is taking out a loan against your account. In fact, more than one-fourth of 401(k) participants who are eligible have an outstanding loan, according to Aon Hewitt.
Now, a 401(k) loan isn't the worst thing you can do with your retirement savings. Borrowing money from your account and paying it back with interest at least ensures you some return on your money. However, there are some pretty good reasons to avoid doing this.
First of all, when you borrow, you're missing out on the growth potential of your money. 401(k) loans generally charge relatively low interest rates -- the prime rate plus 1 percentage point seems to be most common. Meanwhile, money invested in an S&P 500 index fund has historically returned close to 10% per year. The interest you'll pay yourself is unlikely to match the returns you'd get by simply leaving the money invested.
Additionally, if you become unable to repay the loan, it will be treated as a withdrawal and subject to income tax, as well as a 10% penalty if you're under 59-1/2 years old. This can also be the case if you leave your job -- many plans require immediate repayment if you quit.
There are a few good reasons to take a 401(k) loan. It's generally better than financing a large purchase with a high-interest credit card, and it can be a useful resource to have in an emergency. As a general rule though, it's smart to seek alternative financing before borrowing the money you've set aside for retirement.
When your 401(k) becomes an emergency fund
Brian Stoffel: There's a rather unfortunately named behavior that many workers participate in every year: 401(k) leakage. This happens whenever someone takes money out of their retirement savings accounts to help pay for present-day expenses. This can occur through in-service withdrawals or by simply cashing out your 401(k) when you switch jobs.
Researchers at Boston College's Center for Retirement Research have attempted to show how damaging such leakage can be. The results show that in a typical year, about 1.5% of all IRAs and 401(k)s suffer some type of leakage. When they tried to show what that means for the average American, it came out to a nest egg that was $94,000 smaller than it would have been without any leakage.
That's a lot of money. Obviously, sometimes such withdrawals are truly necessary. But some of the time, people tap their 401(k)s for discretionary spending, such as financing wedding costs, a car, or a new house. Before making such decisions, consider that the money you are taking out will never have the chance to compound. In the end, most leakages occur because people are buying something they want (don't need) today and trading out money they'll likely feel like they need come retirement time.
