Every single person who's saving and investing for retirement will make mistakes -- mistakes are a fact of life and unavoidable. The thing with investing, though, is oftentimes the worst mistakes are ones that we don't even realize we are making.
With that in mind, we asked three of our top retirement planning contributors to weigh in on critical 401(k) mistakes that people need to avoid. Keep reading to see what they had to offer.
Letting the "default" options hurt your returns
Dan Caplinger: For many people, just signing up for a 401(k) retirement plan account is a tough obstacle to overcome. But even once you sign up for an account, you also have to be smart about how you go about investing your 401(k) money.
Typically, if you don't specify a certain investment option for the contributions you make to your employer-sponsored retirement plan account, the plan itself chooses a default option for you. In the past, that default used to be the money market cash options, which had rock-bottom returns that didn't even keep up with the rate of inflation. At that time, it was absolutely critical to make sure you choose a more appropriate investment vehicle that could grow over time.
Recently, though, regulators who oversee 401(k) plans gave employers better options for investing money. Specifically, qualified default investment alternatives were established, which included target retirement funds, balanced funds, and services that automatically spread contributions across plan options to create a reasonable mix of assets. For those whose employers have followed these rules, the consequences of not selecting your own investments aren't as serious. But it still makes sense to tailor your investments to your individual needs so that you can tie them in to your other financial resources and come up with the best overall investing plan.
Thinking you can catch up when your income is higher
Jason Hall: A common 401(k) mistake people make is putting in minimal (or no) contributions when they are young, choosing to wait until their earnings are higher, and "catching up" then. The problem with this approach is that it ignores how valuable the earliest contributions are to your long-term wealth accumulation.
Here's an example that should make it clear that there's never a better time to raise your 401(k) contributions than now:
If you were to start contributing $10,000 per year to your 401(k) at age 45, you'd accumulate $545,000 at age 65, based on an 8% annualized rate of return. Now, if you'd contributed $1,200 per year from age 25 to 44, you'd reach 65 with more than $843,000 in retirement funds.
That's right. An extra $24,000 invested starting at a younger age has the power to generate nearly $300,000 in retirement savings. Even by age 45 -- when our theoretical investor ramped up their retirement savings -- that $24,000 in contributions would have grown to nearly $60,000.
That's how relatively small numbers can grow quite big over time. And it's a very big mistake to ignore that rule and put off investing in your 401(k) as early as you can.
Cashing out when you change jobs (and setting yourself further behind)
Selena Maranjian: One of the worst mistakes you can make with your 401(k) -- and, sadly, a rather common one -- is to cash it out when you change jobs or leave your job. At such a time, you can usually leave the money in the account, transfer the money into your new employer's 401(k) plan, transfer the money into an IRA, or cash out.
Cashing out is short-sighted, and it short-changes your future, too. Some folks cash out because they view the account as a windfall. That's terrible, because it's not meant to be a short-term savings account but a long-term vehicle to help fund your retirement. Don't make the mistake of assuming that the account is too small to make much of a difference. Even if you only have $20,000 in it, if that sum remains invested for another 20 years and grows by an average of 10% annually, it will end up worth almost $135,000. That can go a long way in retirement. Indeed, if you make 4% of that per year in retirement, it will give you more than $5,000 per year, or close to $450 per month.
Keep in mind, too, that if you're withdrawing funds from your 401(k) before you hit age 59 1/2, you'll have to fork over a 10% penalty to Uncle Sam, not to mention having to pay taxes on the withdrawal.
If you leave your job, it's often best to roll over any 401(k) money into your new 401(k) account or into an IRA. Few of us have pensions to look forward to these days, and the average Social Security retirement benefit was recently only about $16,000 per year. Let any money you have in your 401(k) keep working to build you a more comfortable retirement.