401(k) Mistakes You Didn’t Know You Were Making
Avoid Making Big Mistakes in Your Retirement Savings Plan
Saving for retirement is something we all know that we should be doing. The ease and convenience of having your contributions automatically deducted from your paycheck can be a major enhancement to your retirement possibilities. When you add on the tax savings from Uncle Sam it is no surprise why 401ks are a popular way to prepare for retirement. Despite a widespread understanding that most of us need to save for retirement, only around 68 percent of employees with access to a retirement plan through their employer are actually participating in an employer-sponsored retirement plan.
If you are currently saving for retirement in a 401k you have already taken a step in the right direction. But you cannot let your guard down and become complacent. While you may rest at ease thinking you are one of the fortunate ones able to save for retirement, it is important to realize that just participating may not be enough. If you aren't paying attention you may be making some major mistakes in your 401k plan that you may not be aware of.
Here are seven of the biggest mistakes 401k investors are making (and how you can overcome them):
Saving without knowing how much you will likely need to retire comfortably.
Predicting exactly how much money you will need to live comfortably isn't easy. Still, many retirement savers make the mistake of not having some basic retirement saving goals in place that they can strive to achieve. Lack of awareness regarding how much you need to be setting aside to achieve a sense of financial freedom will likely result in some bad consequences.
The good news is that running a basic retirement calculator at least once per year can improve your chances for success. Running a few ballpark estimates is helpful even if you have decades to go until retirement and your vision of life after work is a little fuzzy. The sooner you start running a retirement estimator the more time you’ll have on your side to make any necessary adjustments.
The Solution: Start by creating a simple definition of what financial freedom means to you. This will help you begin thinking about the lifestyle you would like during retirement—however you choose to define it. There isn’t a “magic number” that works for everyone. Conventional wisdom suggests the average person will need to replace around 70 to 90 percent of pre-retirement income to maintain a comfortable lifestyle. The most important thing you can do is to start thinking how much you will likely need based on your lifestyle goals.
If you aren’t sure what your acceptable income range is, run some retirement calculators to see if you are on the right track toward a secure retirement.
Saving too little.
In recent years, many employers have shifted to the auto-enrollment of new employees in 401k plans. This can help increase retirement plan participation rates, but if the automatic enrollment amount isn’t enough to help you reach your personal goals then you may have an income shortfall. Unfortunately, many employees blindly accept the default amount setup during auto-enrollment programs. The average amount saved in a 401k plan is around 6 percent. Even when you add an additional 3 percent matching contribution you may find yourself behind on your savings plan.
While not saving anything for retirement is a big problem, not saving enough is another major mistake.
So exactly how much is enough? While the amount you need to save will vary based on your personal goals, many experts suggest saving a target goal of 10 to 20 percent of your income. This can be frustrating to hear if you are trying to make ends meet and pay for current financial obligations. If you are paying off high interest debt or still trying to build up your emergency savings then it usually makes sense to contribute enough to at least get the company match.
The Solution: The obvious answer if you aren’t saving enough is to save more. But that may seem a bit daunting if you are already trying to balance competing priorities. Review your spending plan and see if you can make any adjustments to increase your 401k contribution rate today. Then, avoid falling victim to those good intentions to save more tomorrow by making a commitment to automate future increases. Contribution rate escalator features in 401k plans allow you to automatically bump up your savings over time.
This automatic rate escalation calculator will help you see how much these small changes can change your retirement outlook.
Failing to pay any attention to fees.
If you only pay attention to a few things about investing, paying attention to the fees should always be on your “things that matter” radar. While your 401k account balance at the time you retire will determine how much income you will ultimately receive, the fees and expenses in your plan will gradually work to reduce your potential growth. Keep in mind that 401k plan fees and expenses generally fall into three categories: plan administration fees, investment fees, and service fees. The financial services industry has gotten better at disclosing fees, but it still can seem overwhelming for the average investor to figure out how much you are really paying in fees and expenses within 401k plans.
The Solution: Review your plan documents to see if you can determine how much you are paying in your 401k plan. Larger plans tend to have lower expenses. Other tools include the Fund Analyzer tool provided through FINRA. If you have an old 401k plan from a previous employer, be sure to compare the fees to your current plan to help you decide if a 401k or IRA rollover makes sense.
Understanding 401k Plan Fees and Expenses
Putting too much in your company stock.
Investing in company stock provides significant growth potential comes with potential risk. One of the biggest disadvantages of having employer stock in your retirement plan is that large company stock holdings may increase the volatility of your retirement portfolio. Fewer 401k plans are using company stock for matching contributions. But there are still many employers that give employees the option to invest in corporate stock within the 401k.
The Solution: Assess how much risk you are exposed to if your 401k plan includes company stock. Try to keep your overall exposure to any individual stock to no more than 10 to 15 percent of your total retirement portfolio.
Failing to rebalance your investments.
It’s no secret that investments rise and fall over time. The general premise behind asset allocation is that certain asset classes (e.g., stocks, bonds, real assets, cash) do not always rise and fall together. As such your original game plan to diversify across different asset classes may drift over time.
The Solution: You may choose to participate in an automatic rebalancing program if one is offered in your 401k plan. As an alternative, investing in target date retirement funds or asset allocation mutual funds will help you take a more hands-off approach to rebalancing your investments on a consistent basis.
Stopping your contributions at or below the company match.
Matching contributions represent free money from your employer. If your employer matches any percentage of your 401k contributions it often makes sense to at least contribute enough to take full advantage of the match. It’s free money!
The 401k contribution limit is $18,000 in 2017 ($24,000 if you are 50 or older).
The Solution: Review your benefits package to see exactly how much your employer will match in your 401k (if anything). If you aren't at least getting the match you should take advantage of this incentive. If you are already contributing enough to receive the full matching contribution, consider increasing your contributions above the match.
Not using Roth option during early career or when in a lower tax bracket.
Roth 401k contributions are made with after-tax dollars. With traditional pre-tax 401k contributions the tax benefits come up front as they lower your taxable income during the current tax year. When you begin taking money out of your pre-tax 401k accounts during retirement the withdrawals are treated as taxable income. In contrast, Roth 401ks allow your earnings to grow tax-free. This typically benefits those who do not need to lower their taxable income today or anticipate being in the same or higher income tax bracket during retirement.
The Solution: Compare the differences between traditional pre-tax contributions and the Roth 401k. Decide whether it makes more sense for you to receive the known tax benefits of using pre-tax savings today versus the uncertainty of future tax savings in the Roth 401k.