In a recent article, “Are You Smarter Than a Fifth Grader? You Better Be If You Want to Participate in a 401(k)”, I mentioned that a basic financial education might help prevent investors from making common mistakes with their 401(k) accounts. What are those mistakes? Here are the top five blunders to avoid with your 401(k) in 2015 and a preferred outcome for each situation.
1) Using your 401(k) as an emergency fund. It’s all too common for participants to cash out their accounts if they have an emergency or when they leave a job. Withdrawals before age 59 1/2 are subject to a 10% penalty and ordinary income tax, in which case you end up losing 30 to 50 cents of every dollar in your account to the IRS. Preferred Outcome: make sure you have sufficient emergency funds before starting a 401(k). When changing jobs, roll your 401(k) to the new 401(k) or an IRA, or leave it at the old plan, if possible.
2) Contributing only up to the company match. Getting every matching dollar available is a smart idea, but a significant number of participants contribute only up to this level. Just because the company matches 4%, doesn’t mean 4% will be enough to generate the amount of money you need to retire! Preferred Outcome: aim to save 10-15% of your salary for retirement. If you can, contribute the maximum to your 401(k), which is $18,000 for 2015, or $24,000 if over age 50.
3) Giving up when the market is down. No one likes to open their 401(k) statement and see that the account is worth thousands of dollars less than the previous month. Unfortunately, if you move into a money market fund, or worse, stop contributing, you may actually be making things worse. Preferred Outcome: focus on your long-term goals and not short-term fluctuations. When the market is down, consider it an opportunity to buy shares on sale.
4) Not Being Diversified. Although it’s tempting to pick the fund with the best 1-year return, there’s no guarantee that particular fund will continue to outperform. (In fact, it’s quite unlikely.) Other participants put their 401(k) into a money market fund, which is almost certainly going to be a poor choice over 10 or more years. Your best bet is to be thoroughly diversified in an allocation appropriate for your age and risk tolerance. Preferred Outcome: develop a target asset allocation; if in doubt, use a target date fund to make these decisions for you.
5) Taking a 401(k) Loan. While taking a 401(k) loan is an option, I rarely meet participants with significant balances who take loans. You have to pay back loans with cash, not salary deferrals, which means that many participants stop their contributions in order to pay back the loan. Any amount not paid back on time is considered a distribution, subject to taxes and the 10% penalty, if under age 59 1/2. Additionally, if you change jobs or are laid off, you will have to pay back the loan within 60 days. Preferred Outcome: don’t sabotage your retirement by taking a loan. Consider other options first.
At Good Life Wealth Management, we know how important 401(k) plans are to your retirement planning. And that’s why all our financial plans include detailed recommendations for each of your accounts.