Everyone wants to have a comfortable retirement, but many aren't quite sure how to get there. A 401(k) can be an excellent tool for growing your nest egg, but if it isn't managed carefully, you may be disappointed with the returns.
Here's a look at three 401(k) mistakes that could put your retirement in jeopardy.
Not contributing to it
This may seem like a no-brainer, and yet millions of Americans who have access to a 401(k) don't take advantage of it. Perhaps the problem is they don't realize what a powerful saving tool it is.
401(k)s help you save for retirement in two ways. First, the money you contribute to a 401(k) comes off of your taxable income for the year (unless it's a Roth 401(k)), so you'll pay less in taxes. Second, the power of compounding will grow your money at a rate that far outstrips the average savings account interest rate. Current savings account interest rates average around 0.08%, but depending on how aggressively you invest your 401(k) funds, it's possible to grow your money by, say, 5%, 8%, or even more per year.
To give you some idea of how rapidly your money can grow, let's imagine that you contribute $5,000 per year to your 401(k) for 30 years. That's a total investment of $150,000 on your part. But that doesn't factor in compound growth. If you earn an 8% rate of return -- which would require a pretty stock-heavy portfolio -- that $150,000 investment will grow into nearly $626,000 by the end of that 30 years.
If your employer offers a good 401(k) plan, you should contribute as much as you can to it each year. In 2018, maximum contribution is $18,500 except for workers aged 50 and older, who can contribute up to $24,500. The sooner you start saving, the better -- because your money will have more time to grow.
Some employers will match the contributions you make, up to a certain percentage of your income. The median match is 3% of your salary, according to the Bureau of Labor Statistics. This may be a dollar-for-dollar match on 3% of your salary or $0.50 on the dollar up to 6% of your salary. So if you make $50,000 per year and you contribute $5,000 to your 401(k), your employer might pay $0.50 for every dollar you contribute up to the first 6% of your wages, or $3,000. That would net you an additional $1,500 per year. If you contribute this amount every year for 30 years, you would end up with over $800,000.
If you're not contributing to your 401(k) at all, or if you're only contributing a small amount, you're missing out on all of this potential growth, and you may struggle to save enough for retirement on your own. If a 401(k) isn't available through your job, you can always open up an IRA instead so you can still take advantage of the tax breaks and compound growth.
Borrowing from it
It's possible to borrow up to half of the money in your 401(k) if your plan allows loans. However, this is a bad idea. For one thing, when that money isn't in your account, it cannot earn compound interest. If you borrow $5,000 from your 401(k) and repay it over five years with 6% interest, you'll end up with $1,147 less in your 401(k) than you would have if you'd just left the money where it was, assuming you earned an 8% rate of return.
401(k) loans also have several taxes and fees that may negate their benefits. When you borrow from your 401(k), you must make quarterly payments and pay back the entire balance of the loan, plus interest (which goes back into your own account), within five years. The exception to this is if you use the 401(k) loan to purchase a home. If you fail to do this, the money will be considered a distribution, and it will be hit with income tax. On top of that, those under age 59 1/2 will also have to pay a 10% early withdrawal fee. Depending on how much you borrowed, this could set your retirement savings back considerably.
If you're in desperate need of money, consider asking for a loan from family or friends or taking out a personal loan before dipping into your 401(k). And if you absolutely cannot avoid it, you should only borrow as much as you feel confident you can pay back within the five-year period so that you aren't charged penalties.
Not moving funds to a better account when you change jobs
You aren't required to do anything with your 401(k) when you leave your job, and many people choose to leave it where it is because it's easier. However, this isn't always the smartest decision. You will no longer be able to contribute to that account, but you will continue to be charged administration and investment fees, which are usually a percentage of your assets. If your plan charges high fees, this could eat into your profits. It's a good idea to look at your 401(k) plan summary and the prospectus documents for your investments to figure out how much you're paying. Anything more than 1% of your assets is not worth it.
In that case, you're better off transferring the money to a new 401(k) or to an IRA with lower fees. You can transfer the money directly to a new account by filling out the appropriate paperwork and requesting the transfer. You can do this by contacting your former employer's plan administrator and requesting a direct rollover. Or you can cash out the account, but this is dangerous, because if you don't get the money into a qualifying retirement account within 60 days, you will be taxed for an early distribution.
A 401(k) is an investment in your future. If you want to give yourself the best chance at a relaxing and secure retirement, it's important to use it responsibly. That means contributing as much as you can, not borrowing from the account if you can help it, and thinking carefully about what to do with your old 401(k) if you leave your job. And if you ever run into any questions about your 401(k), don't hesitate to ask someone, whether it's your employer, a financial advisor, or a knowledgeable family member or friend. You don't want to take any chances.