Few of us have pensions these days, as companies are now far more likely to offer workers 401(k) accounts with which to save for their retirements. It's not exactly a great deal, as risks and responsibilities have been transferred from employers to employees.

If you want to amass enough money for your retirement, it's probably largely up to you to do so, by making good use of available retirement accounts and by investing effectively in them. Here's a look at 401(k) accounts and how to make the most of them, avoiding costly blunders.

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What's a 401(k)?

Pensions are often referred to as "defined benefit" plans, as they offer a certain sum in retirement, with employers on the hook to have those promised funds available when needed. Defined benefit plans have now been superseded by "defined contribution" plans such as 401(k)s, where the amount contributed to the account is the known sum -- with the ultimate benefit unknown, generally determined by investment results.

A 401(k), then, is an account offered by an employer that receives contributions from employees, typically directly through payroll and typically as a percentage of salary. A worker might, for example, have 8% of his paycheck routed directly into his 401(k) account. It's also very common for employers to match those worker contributions, in some way. A common match formula is 50% of what the employee contributes, up to 6% of salary. So if you contribute 6% of your salary, your employer will chip in 3%. (And if you contribute 8%, your employer will chip in... 3%.)

As of September 2019, about 55 million employees and millions of former employees and retirees had nearly $6 trillion socked away in 401(k) accounts. That represents 19% of America's total retirement assets, per the Investment Company Institute. Indeed, about 25% to 30% of our retirement income comes from 401(k) accounts, according to an estimate from 2016.

The power of a 401(k) account for retirement savings

A good start on your path to avoid making errors with your 401(k) account is to appreciate just how powerfully it can help you save for retirement. Part of the reason for that is because while you can only contribute up to $6,000 to your IRA(s) in 2020 (plus an additional $1,000 if you're 50 or older), the 2020 contribution limits for 401(k)s are much more generous: $19,500 plus $6,500 if you're 50 or older, for a possible total of $26,000.

Most people can't sock away $26,000 each year, but the table below shows how much you might amass over time investing various sums regularly and earning an average annual return of 8%:

Years of 8% Annual Growth

Balance if Investing $10,000/Year

Balance if Investing $15,000/Year

Balance if Investing $20,000/Year

5 years

$63,359

$95,039

$126,718

10 years

$156,455

$234,683

$312,910

15 years

$293,243

$439,865

$586,486

20 years

$494,229

$741,344

$988,458

25 years

$789,544

$1,184,316

$1,579,088

30 years

$1,223,459

$1,835,189

$2,446,918

Source: Calculations by author.

Don't assume that amassing $1 million is out of reach for you. According to Fidelity Investments, which oversees millions of Americans' retirement accounts including gobs of 401(k) accounts, nearly 200,000 of those folks had 401(k) account balances topping $1 million, as of the middle of 2019. Fidelity has also noted that most 401(k) millionaires have been saving and investing for around 30 years. The average account balance for those saving for 10 years topped $300,000.

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401(k) mistakes that can cost you a lot

It's clear that you'll need to be diligent if you want to build wealth with your 401(k) account. You'll also want to avoid common pitfalls. Here are 12 common 401(k) mistakes that could cost you a lot, followed by a closer look at each:

  1. Not participating in your 401(k) plan
  2. Not contributing enough to your 401(k)
  3. Not increasing your 401(k) contributions regularly
  4. Not contributing enough to get the full employer 401(k) match
  5. Loading up on too much company stock
  6. Staying with your 401(k) plan's default investment choices
  7. Picking the wrong mutual funds and investments
  8. Ignoring fees in your 401(k)
  9. Not considering the Roth 401(k)
  10. Ignoring important 401(k) rules
  11. Cashing out or borrowing from your 401(k)
  12. Not appreciating the downsides of 401(k)s

No. 1: Not participating in your 401(k) plan

The first thing that can go wrong is if you don't actually participate in a 401(k) account that's available to you. Most folks who can, do -- about 85% as of 2016, per the Plan Sponsor Council of America. But those not doing so may be leaving a lot of money on the table. After all, if you miss out on a few years of saving and investing, you not only fail to have those savings in your account, but you also lose out on the gains those sums would have produced. That's why it's possible, by putting off saving and investing for just five years, to lose out on more than $400,000.

Young people are likely to assume that they can safely not think about retirement for a bunch of years, but they end up squandering the power of time when they do so. Even small sums socked away when you're young can grow to large ones. Check out the table below, and imagine what you might gain by investing multiples of $1,000 over many years:

Years of 8% Growth

Final Value of a Single $1,000 Investment

5 years

$1,469

10 years

$2,159

15 years

$3,172

20 years

$4,661

25 years

$6,848

30 years

$10,063

35 years

$14,785

40 years

$21,725

Source: Calculations by author.

No. 2: Not contributing enough to your 401(k)

The next mistake is one of magnitude: not contributing as much as you could to your 401(k) account. The median contribution to 401(k) accounts has been about 6% for several years in a row, per Vanguard data. That's considerably less than the rule of thumb that we should be socking away 10% of our income -- and even that rule of thumb isn't enough for many people who are behind in their savings.

It can be well worth your time to do a little budgeting, figuring out where your money is going, so that you can cut back on unnecessary spending and route funds to where they're needed -- such as in retirement accounts.

No. 3: Not increasing your 401(k) contributions regularly

Once you're regularly socking away what seems like a reasonable sum into your 401(k) account, don't stop there. Every year or so, ask yourself whether you can increase that amount -- and try hard to do so, as it can make a big difference.

Check out the tables below, from Fidelity, which show the power of upping your contributions by a percentage point annually. They reflect a 25-year-old starting out with a $40,000 income:

Increase

Change in Monthly Income in Retirement

Change in Annual Income in Retirement

One-time 1% increase

$190 more per month in retirement

$2,280 more per year

1% increase every 5 years for 25 years

$690 more per month in retirement

$8,280 more per year

1% increase every year for 12 years

$1,930 more per month in retirement

$23,160 more per year

Source: Fidelity.com. 

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No. 4: Not contributing enough to get full employer 401(k) match

Remember that employer match? There's a very good chance that your employer offers a matching contribution, and if you're not contributing enough to your account to grab all available matching dollars, you're leaving money on the table. That's free money, after all!

According to a 2019 report from Vanguard, these are the two most common kinds of employer matches:

  • $0.50 per $1.00 contributed by the employee on the first 6% of pay
  • $1.00 per $1.00 contributed by the employee on the first 3% of pay, plus $0.50 per $1.00 on the next 2% of pay

The first formula above caps the employer contribution at 3% of pay, and the second caps it at 4%. If you earn, say, $60,000, you'd be looking at $1,800 or $2,400 in free money.

Remember, too, that plenty of companies offer much more generous matches (though, of course, some offer less generous ones). It's worth factoring a potential employer's match into your decision-making.

No. 5: Loading up on too much company stock

Another common error is filling your 401(k) with too much of your employer's stock. Yes, it does make sense to invest in your employer because it's likely the company you understand the best. But there's a big danger: If it implodes -- think Enron, for example -- it can wipe out not only your ongoing income, but also your retirement savings. That would be a terrible blow to your financial security.

Don't think that an implosion is close to impossible, either. Many companies one would never have imagined going out of business did just that, sometimes surprising many people, including employees. A company doesn't even have to go out of business to severely hurt employees and former employees who have heavily invested in its stock -- simply having its stock plunge can do it. That has happened to stalwarts such as General Electric, whose stock is down about 57% over the past three years, as of this writing.

For safety's sake, you might limit the value of your stock in your employer to about 10% of your overall portfolio -- if not 5%, to be more conservative.

No. 6: Staying with your 401(k) plan's default investment choices

When you start participating in your employer's 401(k) plan, you will get to choose where your contributions are invested from a menu of options. Fail to do so, and they will be plunked in default choices, which are likely to be ultra conservative. Many participants actively choose the default investments, not knowing any better. What's wrong with that? Well, a very safe investment is likely to be one that grows very slowly, and if you're trying to grow your money powerfully over many years, that works against you.

Any short-term money shouldn't be in the stock market, as it can be volatile from year to year. But the stock market is the best choice for most of us for long-term dollars, as few alternatives can top it. The table below offers annualized returns for various kinds of investments from the period 1802 to 2012 -- yes, 210 years.

Asset Class

Annualized Nominal Return

Stocks

8.1%

Bonds

5.1%

Bills

4.2%

Gold

2.1%

U.S. Dollar

1.4%

Source: Stocks for the Long Run, Jeremy Siegel.

It's clear that stocks are faster growers. But you might not appreciate the difference a few percentage points can make. So take a gander at the table below, showing how a $10,000 annual investment would grow over time at those different growth rates:

 

10 years

20 years

30 years

In Stocks at 8.1%

$157,345

$500,201

$1.2 million

In Bonds at 5.1%

$132,812

$351,219

$710,383

In Bills at 4.2%

$126,270

$316,806

$604,318

In Gold at 2.1%

$112,309

$250,561

$420,750

In the U.S. Dollar at 1.4%

$108,033

$232,179

$374,843

Source: Author calculations.

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No. 7: Picking the wrong investments

It's often smart to avoid the default investments, but that's not enough. You might still make bad investment choices, and that can hurt your long-term results.

For best results, take a little time to learn more about mutual funds and exchange-traded funds (ETFs), which are more likely to be among your choices. Mutual funds and ETFs can be invested in stocks, bonds, and/or a mix of various kinds of assets. You may want to include a bond investment or two in your choices, for diversification's sake -- though bonds are likely to appreciate more gradually than stock index fund investments.

Know that mutual funds are either actively or passively managed. Actively managed ones have financial professionals studying investments, choosing which ones to buy and when, and aiming for great results. Passively managed funds, such as index funds, simply hold mostly the same investments as in a benchmark index, in roughly the same proportion, in order to achieve pretty much the same results. Since those funds' managers have much less to do, the funds tend to charge far less in fees -- and over time, they have outperformed the vast majority of their more actively managed counterparts. Indeed, as of the middle of 2019, fully 90% of large-cap stock funds underperformed the S&P 500 over the past 15 years. So consider favoring low-fee, broad-market index funds, such as ones that track the S&P 500.

No. 8: Ignoring fees in your 401(k)

The next error many people make is ignoring the fees that they're charged in their 401(k) accounts. Let's start with the fees associated with the mutual funds in the plan's menu. You might reasonably have options such as a managed fund that charges an annual fee ("expense ratio") of 1.1% (many charge much more) and an index fund that charges 0.1% (many charge even less). Here's how that single-percentage-point difference can affect your results over time, if you were investing $10,000 annually and achieving an average annual gain of 10%, pre-fee:

Investing Period

Balance Assuming 8.9% Growth

Balance Assuming 9.9% Growth

10 years

$164,663

$174,315

20 years

$550,920

$622,348

30 years

$1.5 million

$1.8 million

Source: Calculations by author.

Meanwhile, 401(k) accounts have other fees that they charge account holders, such as for management of the accounts. You might ask your benefits department how much the fees are, and you might look up your company's 401(k) plan at a site such as BrightScope.com, which lets you know how it compares to others in terms of fees and matching generosity.

Don't assume that your plan's fees are reasonable, because they sometimes aren't. Workers at companies such as Oracle have sued their employers, alleging that they have been charged too much in fees. (Oracle settled that suit.) If your plan's fees are onerous, you might opt to not participate and just save via IRAs and other retirement accounts, or you might participate only enough to get the free matching dollars.

No. 9: Not considering the Roth 401(k)

IRAs have come in the traditional and Roth variety for a long time, and many people don't realize that most employers with 401(k) plans offer Roth 401(k) accounts to their workers, too.

With a traditional IRA or 401(k), you contribute pre-tax dollars, which shrinks your taxable income, giving you a nice upfront tax break. (For example, if you earn $60,000 and contribute $5,000 to your traditional account, your taxable income falls by $5,000, letting you pay less in taxes. You're only taxed in the future, when you withdraw money.

Roth IRAs and 401(k)s accept contributions on a post-tax basis, meaning that you get no upfront tax break. But if you follow the rules, you can withdraw funds from the account in retirement tax-free. The Roth 401(k) isn't always your best choice, but it may well be. Read up on Roth 401(k)s and see what will serve you best.

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No. 10: Ignoring important 401(k) rules

The U.S. tax code is long -- featuring some four million words! (That's about four times as long as the entire Harry Potter series.) It's long because it's full of rules and details -- many of which we need to know, lest we run afoul of the IRS. There are some important 401(k) rules to know and follow, too.

For example, you'll need to leave your money in your account until you're at least 59 1/2 years old, otherwise you'll likely face a 10% early withdrawal penalty. The penalty doesn't apply in some cases, though, such as if you're retiring early because of a qualifying disability or are facing a qualifying financial hardship. Also, if you leave a job in or after the year in which you turn 55, you can make 401(k) withdrawals without penalties.

Another critical rule concerns "required minimum distributions" or RMDs, which apply to traditional (but not Roth) IRAs and both traditional and Roth 401(k)s. RMDs are sums you must withdraw from your account each year beginning on "April 1 following the later of the calendar year in which you reach age 70 1/2 or retire," per the IRS. Breaking this rule can be very costly, as the penalty is 50% of the sum that you didn't withdraw.

Finally, you need to understand vesting rules. When your employer contributes to your 401(k) account, that money might be all yours immediately -- in which case you'll be fully vested. But many companies have more complicated vesting schedules. It's not uncommon, for example, for a vesting schedule to give you ownership of the first 25% of your employer's matching money immediately, followed by another 25% in a year, a further 25% the year after, and the final 25% the year after that. These vesting schemes are designed to keep employees around.

No. 11: Cashing out or borrowing from your 401(k)

This costly 401(k) mistake is exceedingly common: cashing out or borrowing from your account. Cashing out often happens when someone leaves a job, while borrowing from a 401(k) happens during one's tenure at a job. There are good reasons to avoid doing either, though.

Both moves remove your money from your account, where it's diligently growing for you. If you're still quite young with only a modest sum in your account, you might think it's no big deal to cash it out. But if you remove, say, $20,000 when you're 30, and it would have grown at an annual average of 8% over the next 30 years, it would have amounted to more than $200,000 -- a sum you're giving up, and one that would have been very handy in retirement. (Indeed, it could have bought you a valuable annuity income stream.)

Borrowing has a similar effect. You might only remove a sum for five years, but that significantly shortens the time your money has in which to grow. Also, many borrowers ultimately find themselves unable to pay back the money, in which case it becomes an early withdrawal, subject to taxes and a 10% penalty.

No. 12: Not appreciating the downsides of 401(k)s

Finally, don't make the mistake of thinking that 401(k)s are perfect retirement savings vehicles. They're not. They can be powerful retirement savings aids, especially when the fees they charge are low and the menu of investment options they offer is good. But IRAs offer similar benefits and let you invest far beyond a limited menu of mostly funds. In an IRA, you can invest in just about any stock and, often, hundreds or thousands of mutual funds, including ultra-low-fee index funds.

Think through the issue of taxes, too. If you expect to collect a lot of dividend income, for example, know that it will be taxed differently depending on where those stocks are housed. If the dividends arrive in a regular, taxable brokerage account, they'll typically face a tax rate of 0% or 15%. But if they're in a traditional 401(k) account, they'll face taxation as ordinary income, and your tax bracket in retirement may be well above 15%. In a Roth 401(k), of course, or a Roth IRA, there will be no taxation at all.

The bottom line

There are lots of mistakes we can make with 401(k) accounts, but the ones above are likely to be the costliest. Learn what not to do, and you may be able to end up with an account worth tens of thousands of dollars more than if you'd made some big blunders.

The more you know, the more wealth you can build.