Earlier, I wrote about some of the common 401(k) mistakes that that can hurt your retirement nest egg. In this article, I list a few more common 401(k) mistakes that every 401(k) participant should be aware of and avoid whenever possible.
Borrowing from your 401(k)
Consider the merits and demerits of borrowing from your 401(k) before you dip your hands into the retirement savings to finance your present requirement. Although it may appear easy and inexpensive compared to commercial loans, borrowing from your 401(k) reduces retirement savings and you repay the loan with after tax dollars. There is a risk of attracting 10% withdrawal penalty and taxes in case you don’t repay your loan on time. You also interrupt the magic of compounding within your tax-deferred account. If you leave or lose your job, you will have to pay the full loan amount, typically, within 60 days.
Cashing out your 401(k) funds too soon or too late
Almost a third of retirement savers cash out their 401(k) when they leave or change their job. If you withdraw your 401(k) funds before the age of 59 ½ (55 if you retire early or quit your job), you will incur a 10% early withdrawal penalty except under exceptional circumstances. Unless you re-invest this amount elsewhere, you are also stopping this money from growing and harming your prospects of having more money during retirement.
On the other hand, IRS will impose excess accumulation penalty if you do not take required minimum distributions (RMDs) starting at the age of 70 ½. Not taking 401(k) withdrawals until they become required can put you in a higher tax bracket if you have a large 401(k) balance.
Mistakes when changing jobs
When moving from one job to another, you can either roll over the 401(k) into an IRA or move the funds to your new employer’s 401(k) plan, if its allowed.
Consider all these factors before making this important decision. Barring a few exceptions, you should not leave the money in your 401(k) with your old employer. Maintaining multiple 401(k) accounts with different employers can increase your financial paperwork and may be difficult to monitor.
If you are doing an IRA rollover, you should do a direct rollover (trustee-to-trustee transfer) where the cheque from your former 401(k) provider goes directly to the financial institution hosting your IRA. Fumbling a handoff can result in early withdrawal penalty and taxation.
Another mistake (not entirely avoidable in all cases) is to leave the job before the employer’s match or profit sharing contributions are fully vested.
Neglecting your beneficiary
Your primary beneficiary is your first choice to receive retirement benefits upon your death. A contingent beneficiary is designated in the event your primary beneficiary dies with or before you. Neglecting to name both the primary and contingent beneficiaries on your 401(k) can cost your heirs much more in taxes. Without specific beneficiaries named, it is likely that the entire account would have to be distributed within 5 years.
Unlike certain other assets, the passing of a 401(k) account does not follow the terms of your will. Not updating your beneficiary can result in your money going to the “wrong person.” If you still have your ex-girlfriend as your beneficiary, you will be disappointing your spouse and kids.