The 401(k) is one of the most powerful retirement tools out there, and it can help you build a nest egg worth hundreds of thousands of dollars, or more. But in order to make the most of this tool, it's important to know how to use it most effectively.
If you're contributing anything at all to your 401(k), you're already a step ahead of many workers. Only about half of Gen Xers and baby boomers who have access to an employer-sponsored retirement plan such as a 401(k) actually participate in it, a survey from the Pew Charitable Trusts found.
But simply participating may not be enough to establish the savings you'll need to last through retirement. If you're making any of these common mistakes, you could be inadvertently hurting your chances of saving enough to retire comfortably.
1. Not contributing enough to earn the full employer match
Not all 401(k) plans offer matching contributions from your employer, but if you're fortunate enough to participate in a plan that does, take full advantage of them. These contributions are essentially free money, and who would turn down the opportunity to receive free money?
If you're already contributing something to your 401(k), saving a little more to max out those employer contributions may not seem like it would make a big difference. But over time, these additional savings can significantly add up.
Say, for instance, you're earning $50,000 per year and your employer will match your 401(k) contributions up to 3% of your salary. That's $1,500 per year, in this case, or $125 per month. Let's also say you're currently saving $100 per month, earning an additional $100 per month from your employer.
By saving $100 per month (plus $100 from your employer), you'd have around $227,000 saved after 30 years, assuming you're earning a 7% annual rate of return on your investments. But if you'd increased your savings to $125 per month to earn the full $125 match from your employer, you'd accumulate roughly $283,000 in that time period, all other factors remaining the same. In other words, an extra $25 per month on your part could make a difference of $56,000 over a few decades.
2. Not considering how fees affect your savings
No retirement account is free, but not everyone is aware that they're paying fees. In fact, 37% of Americans mistakenly believe they're not paying any 401(k) fees at all, according to a survey from TD Ameritrade, and 22% aren't sure whether they're being charged fees or not.
The average 401(k) charges fees of around 1% of total assets under management, a study from the Center for American Progress found. So if you have $10,000 in your 401(k), you'd be paying roughly $100 per year in fees. That doesn't sound like much, but as your savings grow, so does the amount you're paying in fees. If you amass hundreds of thousands of dollars in your 401(k), a 1% fee could immediately cost you thousands in fees every year.
It can be difficult to figure out exactly what you're paying in fees. The first place to check is within the statements you receive from your plan administrator. Sometimes the fees are buried within these documents, so you can also talk to your human resources representative to get help finding information about fees. You'll probably see several types of fees listed, including investment fees, administrative fees, and service fees. The expense ratio is one of the most important figures to consider, as it's the total percentage of your fund's assets that go toward fees.
If you're stuck paying higher-than-average fees, it may be worthwhile to consider switching to a different retirement account. However, if you're receiving matching contributions from your employer, it's usually best to contribute enough to your 401(k) to earn the full match -- that free money will typically outweigh any high fees. For the rest of your savings, you may choose to open a traditional IRA or Roth IRA with lower fees. Shop around for different accounts to see if you could be earning a lower fee elsewhere or if you're better off staying put.
3. Borrowing or withdrawing from your 401(k)
Your 401(k) may look like a massive savings account with thousands of dollars at your disposal. But to ensure your money grows as much as possible, it's best to leave those savings untouched until retirement.
Nearly a third of 401(k) participants have borrowed from their retirement account, a survey from financial services organization TIAA-CREF found. In addition, of those who took out 401(k) loans, nearly half admitted they regretted their decision, and another 23% said that although they didn't regret borrowing from their 401(k), they wouldn't do it again.
Borrowing from your 401(k) may not seem like a disastrous decision -- after all, you pay the money back, and the interest you pay on the loan goes right back into your account. However, because many plans don't allow you to make additional contributions while you're paying back the loan, you're essentially putting your retirement saving on pause until the money is paid back.
Withdrawing from your retirement account is more troublesome for a couple of reasons. First, you'll be hit with a 10% penalty if you withdraw funds before age 59 1/2. Second, because you're not required to pay back the money you withdraw, you could be undoing all your hard work if you don't increase your savings later to catch up.
Sometimes even relatively small withdrawals can make a big impact over time. Say, for instance, you currently have $25,000 in your 401(k) and you're saving $200 per month. At that rate, you'd have around $417,000 saved after 30 years, assuming you're earning a 7% annual rate of return. But if you'd withdrawn $5,000 (while still contributing $200 per month), you'd only have around $380,000 saved in that same time period. So even though you continued saving and only withdrew $5,000, it could still cost you around $37,000 over time.
Making the most of your 401(k) is an ideal way to prepare for retirement, but not everyone understands exactly how to take full advantage of this tool. However, by saving as much as you can and avoiding some of the common pitfalls, you'll be well on your way to a healthy financial future.