The 401(k) has become a major source of retirement income for many workers since most companies have eliminated defined benefit plans. However, even if you're contributing to your 401(k) plan, you must avoid several mistakes that seriously affect your plan's future value. Here are four mistakes you don't want to make.
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Not contributing enough
It's great that you're contributing to your 401(k) plan since many workers who have access to such plans don't contribute at all. However, if you're counting on your 401(k) to be a major source of income during your retirement years, it's important to contribute as much as possible.
Always contribute at least as much as you need to take advantage of any matching funds your company offers. Otherwise, you're forgoing part of your available compensation.
Financial advisors recommend saving at least 10% of your income. Try to contribute at least this much to your 401(k), and always increase your contribution whenever you get a pay raise. The IRS current limit for employee contributions to a 401(k) plan is $18,000 per year. Ultimately, contributing this amount is your goal, and yes, you may need to contribute more than 10% of your income if you contribute $18,000 per year. Saving more than a recommended minimum toward your retirement is a good thing.
Keep this in mind: The median account value of 401(k) accounts for baby boomers nearing retirement is $120,000.It's recommended that retirees withdraw no more than 4% of the value of their retirement accounts annually. For a $120,000 account, this would equal an initial withdrawal of only $4,800, or $400 per month. Would you be able to maintain your lifestyle with only $400 per month and projected Social Security benefits? If not, contribute more now.
Investing too conservatively in early years
When the stock market crashed in 2008, investors lost a collective $2.4 trillion in retirement accounts and 25% of retirement portfolio wealth for long-term workers. Many seniors about to enter retirement were forced to continue working or adjust their retirement plans while other investors fled from equities. Many investors continue to avoid equities, even when they have decades left before investment income would be needed in retirement.
If you have a long investment horizon, equities should be a part of your investment mix. It's wise to adjust the account allocation to more conservative investments as you approach retirement age, but if you're decades away from retirement, let equities be a prominent part of your investment plan.
Some 401(k) plans automatically enroll plan participants in the most conservative investment options designed to preserve account value. If you don't change the portfolio mix, your contributions may languish in these accounts and you'll miss out on the opportunity for significant growth for your investment. If you don't want to worry about periodically reallocating your portfolio, most companies have targeted retirement-date funds that automatically adjust your allocation to more conservative investments as you near retirement age.
Paying high account management fees
Do you know what fees you're paying in your 401(k) plan? If you don't, you're not alone. Sixty percent of people don't realize they are paying any fees at all in their plans.
Fees have a huge impact on the overall value of your investment. A 2% fee may not sound like much, but over 40 years, it can erode half the value of your investment.
By law, the plan administrator must disclose the expense ratio for all investment options in your employer's plan. Try to choose a fund with a low fee option. If all options in a company plan have high fees, it may be best to contribute only enough to get the company match and then invest in an IRA account.
Leakages
Leakages are withdrawals from investment plans that occur before age 59 1/2. According to a study by the Federal Reserve Board, $0.40 of every $1 contributed to the direct contribution accounts of savers under age 55 eventually leaks out of the retirement system before retirement. These withdrawals can occur as cash-outs, loans, or hardship distributions.
The average cash-out from a job change is $14,300 for participants under 40 years of age. When an account is cashed out, the account holder must pay federal and state taxes and pay an early withdrawal penalty on the distribution. These taxes and penalties can eat up around one-third of the account value. If instead of cashing out, a 30-year-old worker rolled over $14,300 into another 401(k) or IRA account, the value of the investment could grow to over $150,000 by retirement (assuming an 8% annual return).
If you take out a 401(k) loan, you avoid the penalties and taxes, but you will have to pay back the loan with interest, and you lose the benefit of the compounding on the balance you've withdrawn.
A hardship distribution may be withdrawn from a 401(k) plan for certain approved reasons. The withdrawal will be taxed and usually an early withdrawal penalty will be assessed if withdrawn before age 59 1/2. These distributions are not repaid and will permanently reduce the employee's account balance.
Additionally, employees are frequently prohibited from making contributions to their 401(k) plan for six months following a hardship distribution. Between taxes, penalties, permanent reduction of the account balance, and inability to contribute for a time period in the future, these types of withdrawals have a significant impact on an employee's retirement savings.
If you're contributing to a 401(k) plan, you've made an important step toward financial security in retirement. Manage your account wisely by contributing as much as possible, choosing investments wisely, avoiding high 401(k) account management fees, and resisting leakages.
