Avoid these common 401(k) mistakes

Even with all its flaws, 401(k) plan is still the primary retirement vehicle that allows individuals to save a portion of their compensation towards retirement and get a favorable tax treatment for the same. As a defined contribution plan, all risk and responsibility of deciding how to invest the funds in the individual’s account is borne by the employee. For most employed Americans, 401(k) will become primary source of income during their retirement. Hence it is important that employees understand the implication of their actions and avoid the following common 401(k) mistakes to ensure a comfortable retirement.

Not participating

The most important mistake is not participating in a 401(k) plan. That too, not participating when young is a big mistake and shows lack of understanding of the magic of compounding.

A primary reason for not participating is either inertia or lack of awareness. Why do we say this? Research shows that automatic enrollment for 401(k) results in higher participation rates than opt-in programs. Other excuses for not participating include:

  • Not having extra money to save
  • No company match
  • Longer vesting schedule for company match
  • High plan fees
  • Low quality of investment options
  • Stock markets are risky
  • Its hard to get the money out
  • Capital gains inside 401(k) are taxed at (higher) ordinary income rates compared to long term capital gains taxed at (lower) preferential tax rates in after-tax accounts
  • Too young to worry about retirement

Using the money to pay off a high interest debt is probably a valid reason for not participating.

Missing out on the employer match

Most employers match $0.50 for each $1.00 contribution up to 6 percent of an employee’s salary. Many employers who had suspended matching contributions in the wake of 2008 recession, have already restored 401(k) matches and many more will be doing it this year. To borrow a cliche, you would be ‘leaving free money on the table’ if you do not contribute enough to take the maximum match offered by your employer. You also forfeit the employer match if you leave your job before the employer match vests.

Not contributing enough

Even when you participate, you may not be contributing up to the maximum 401(k) limit prescribed by IRS. Many employees save only enough to get the company match. Some choose an arbitrary percentage (usually round number like 5% or 10%) of their salary as their annual contribution. Others choose to freeze contributions at a certain dollar amount and do not (or forget to) increase that amount in spite of raises and bonus. Many employees (over 50) do not play catch-up even when they are nearing retirement.

The most common reason for lower contributions is not having a planned savings goal. Our 401k calculator can help you with retirement planning and estimate how much you need to save each year for a comfortable retirement.  The plan you create should be reviewed at least once every year.

Investment mistakes

Key to successful retirement plan is to save aggressively and invest conservatively. Investment mistakes can be broadly classified into 3 categories:

Not investing according to your risk tolerance

When forced to choose, I will not trade even a night’s sleep for the chance of extra profits. – Warren Buffet

Taking too much risk when approaching retirement will cause you sleepless nights and may erode your nest egg right when you need it. It also leads to avoidable mistakes such as bad market timing and micromanagement of assets. Many baby boomers panicked, dumped their stocks and jumped to cash or bonds at the market bottom in 2008 and missed the market upswing following the crash. This clearly shows that their asset allocation did not match their risk tolerance.

The opposite – not taking enough risk – is also a investment mistake if you are young and have a lot of years before retirement. If you do not invest for growth when young, your savings will barely be able to catch up with inflation. If you are extremely risk averse, you should at least explore index funds.

Market timing and micromanagement

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.  – Warren Buffet

The average 401(k) balance of pre-retirees, who held onto their equities during 2008-09 market downturn, nearly doubled in 4 years while those who abandoned them saw a modest growth of only 26 per cent. It is very important that you stick to your long-term investment plan and not get swayed by short term market fluctuations. For some, there is an attraction to actively managing the 401k portfolio. If you don’t know what you are doing and you are actively managing your portfolio, you know just enough to hurt yourself. If you cannot resist market timing, then you should only do so with a small percentage (say 10%) of your portfolio.

Diversification errors

This can happen due to various reasons:

  • Investing too much in company’s stock
  • Investing mainly in Stocks, Not Bonds
  • Failing to re-balance regularly
  • Misusing Target-Date and Target-Risk Funds
  • Buying a basket of similar funds
  • Diversifying each account instead of your overall portfolio

Other 401(k) investment mistakes include:

  • Choosing mutual funds based on past performance (i.e., investing in that hot mutual fund that everyone is talking about)
  • Not being aware of high fees OR investing in funds with high expense ratio
  • Investing in anything designed to save you taxes inside the tax-deferred 401(k) plan (e.g., holding tax-exempt securities such as municipal bonds)
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