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4 Critical 401(k) Mistakes to Avoid

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If you want to be comfortable in your old age, you need to be diligent about saving and investing for your retirement -- and to avoid critical 401(k) mistakes such as the ones discussed here.

Relatively few workers in America have pensions these days, so it's increasingly up to the workers to provide for their own retirements. Employers help to some degree, often by providing workplace-based retirement accounts, such as 401(k)s. It's great to have a 401(k), but that's not enough. You also have to make good use of it and avoid critical mistakes. Here are four mistakes to avoid. 

Brian Feroldi: One of the biggest 401(k) mistakes you can make is to simply never sign up to contribute to one in the first place. That could prove to be a costly decision in more ways that one, since many employers encourage their workers to contribute by offering free money in the form of a matching contribution. If your employer has a 401(k) that offers a match and you're not taking full advantage, you're essentially saying "no" to a free raise.

While there's no standard matching formula for an employer to follow regarding 401(k) matches, one common match features adding an extra $0.50 per $1 on the first 6% of an employee's salary. That means that if the employee elects to defer 6% of his or her salary toward their 401(k) plan, the employer will kick in an extra 3% for free. That can go a long way toward building up the fund quickly. It's not chump change, either. Since the average American pulled in about $44,569 in wages in 2014, that 3% is equal to more than $1,300 per year.

Thanks to automatic enrollment, the majority of Americans who are eligible for a plan do contribute to one, though often not as aggressively as they could. A 2014 study by Vanguard showed that 76% of workers contributed to their plan each year. Better yet, when adding in both the employee-elected deferral and the employer match, the average contribution rate was a solid 10.2%.

If you're in that 24% of Americans who have access to a 401(k) plan but for whatever reason have yet to participate in it, I'd encourage you to march down to your human resources department right away and sign up.

A simple index fund can perform very well for you over time. Image source: Pixabay.

Jason Hall: Another common mistake 401(k) investors make is investing in actively managed funds. It may seem smart to invest in a fund actively managed by investment professionals. Unfortunately, their results are, on average, just plain bad. Whether you measure their performance in short-, medium-, or long-term, the vast majority of actively managed mutual funds underperform their benchmarks. 

According to an S&P Indices SPIVA report, actively managed large-cap mutual funds underperformed the S&P 500 index by 27% on average last year, with more than two-thirds of active funds underperforming. The long-term statistics are even uglier:

  • Over the past five years, 84% of large-cap funds, 77% of mid-cap funds, and 90% of small-cap funds underperformed their respective benchmarks.
  • Over the past 10 years, 82% of large-cap funds, 88% of mid-cap funds, and 88% of small-cap funds underperformed. 

And it's not just a matter of finding the best active fund and investing in it, since very few funds stay top performers. From the SPIVA Persistence Scorecard:

According to the S&P Persistence Scorecard, relatively few funds consistently stay at the top. Out of 678 domestic equity funds that were in the top quartile as of September 2013, only 4.28% managed to stay in the top quartile by the end of September 2015. Furthermore, 1.19% of the large-cap funds, 6.32% of the mid-cap funds, and 5.41% of the small-cap funds remained in the top quartile.

Bottom line: You're almost definitely better off investing in the low-cost index funds you have available in your 401(k) than in the active funds. Not only will you likely pay smaller fees, but your returns are likely to be much higher. And that means more money when it's time to retire. 

Think twice before cashing out. Image source: Laurie Minor-Penland, Smithsonian Institution.

Selena Maranjian: One of the worst mistakes to make with a 401(k) account is to cash it out when you change jobs. It's easy to imagine that it's not much of a mistake, especially if you change jobs relatively frequently and rarely seem to have much money in your 401(k). But if you stay at one job a long time and make the most of your 401(k), or if you change jobs now and then and keep rolling your 401(k) account from each workplace into an IRA, a new employer's 401(k), or some other retirement account, you can accumulate a lot of money that will likely be rather critical in retirement. (You can often leave the money in your former employer's 401(k) plan, too.) Socking away $10,000 per year in a 401(k) that grows by 8% on average each year can yield almost half a million dollars in 20 years.

Many people don't quite get it, though. According to the Women's Institute for Secure Retirement (WISER), close to 45% of workers cash out their workplace-based retirement accounts when changing jobs. Some of these folks do so because they need the funds -- indeed, plenty of people take money out of their retirement plans without even changing jobs, because of a financial emergency. A survey  found fully one in eight Americans doing so in the past year. Some emergencies may warrant such withdrawals, but in many cases, you may be able to get the money elsewhere, which is a better idea. Even if you were to borrow from your 401(k) and then repay the money later, it can hurt you. Imagine, for example, borrowing $10,000 for three years. If that money had stayed in the 401(k) and grown at an annual average of 8%, it would have become $12,600. By removing it for a while, you lose $2,600.

Matt Frankel: One mistake people make with their 401(k) is automatically rolling their account into their new employer's plan or into an IRA when they change jobs. Before making either of these decisions, there are a few things you need to consider.

First, consider the fees involved. Compare the expense ratios of your current 401(k) funds with those of your new employer's plan, or with those you could obtain with a rollover IRA. If your old 401(k) has the best fees, you're probably better off leaving it alone.

A rollover IRA is a great option for those who want more options and more control over their retirement investments. Unlike with a 401(k), an IRA lets you invest in any stocks, bonds, or funds you want. However, this could be a good thing or a bad thing. If you make risky investments or don't properly diversify your portfolio, it could lose value instead of growing.

As a general rule of thumb, it's best to avoid high-risk, high-reward stocks with your retirement money. Companies such as Tesla Motors and Groupon immediately come to mind. Instead, stick to stocks with a proven track record of consistent growth, strong balance sheets, and little risk of profits falling. Here's an article with a few good examples.

Once you find the right stocks, it's still important to properly diversify. Expert recommendations vary, but I generally tell people to avoid putting more than 5% of their retirement savings in any one stock.

To sum it up, rolling over to choose your own stocks can be a great idea, but be sure to pick the right kind of stocks -- and spread your money around. If you're not comfortable with your own stock-picking abilities, there's nothing wrong with leaving your retirement savings on "autopilot" in a 401(k).

We will all need significant income streams to support us in retirement, and the average Social Security benefit only amounts to about $16,000 per year. If you want to be comfortable in your old age, you need to be diligent about saving and investing for your retirement -- and to avoid critical 401(k) mistakes such as the ones above.

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