Ah, retirement. More time to travel and spend time with loved ones. Sounds great — assuming you can afford it! While it might be decades away, you need to start planning for it now. But you already knew that, right? Still, once a year when your 401(k) rep stops by the office for a presentation, you may find yourself zoning out as they go on about "target-date funds [1]." Hopefully, despite the dry nature of retirement planning, you've decided to set up a 401(k) anyway. That's a great first step! But now you should understand the common pitfalls and how to avoid them. Here are seven.
Mistake 1: Prioritize It Over All Other Financial Goals
Author and financial expert [2] Nicole Lapin says contrary to what you've heard, maxing out a 401(k) isn't for everyone. She cites a few scenarios where you shouldn't prioritize it, like if you don't have a personal savings account that covers six to nine months of bills and expenses. "You need to have liquid, readily available cash to cover expenses if you lose your job or are in a pinch," Lapin says, suggesting young people contribute to their "rainy day" fund before a 401(k). Another case when you shouldn't rush to max out your 401(k): if you have a lot of debt. "If you have a substantial amount of debt, especially with crummy interest rates, then you're better off chiseling away at it early than investing it in the market."
Mistake 2: Fail to Sign Up For Automatic Escalation
You have the option to automatically increase your contributions to your 401(k) as you make more money — and it would be a mistake not to take advantage of it. "You're less likely to spend that money on something else if it never hits your checking account," Lapin says, "and more likely to put it to good use if the ramp up is on auto-drive." If you can't max out the $18,000 allowed annual contribution today, consider opting into a 2 percent increase each year until you get there.
Mistake 3: Invest in High-Fee Plans
A study from Nerdwallet [4] found that just a 1 percent fee could cost you almost $600,000 by the time your retire. So when you are deciding where to direct the money in your 401(k), it pays to read the fine print. Your 401(k) will likely give you a few investment options to choose from. You want to choose a fund that has the lowest "expense ratio," which is charged as an annual percentage of your total investment in the fund. Typically, passively managed index funds have lower fees than mutual funds. When you leave your company, also consider rolling over your 401(k) into an IRA, which likely has lower management fees.
Mistake 4: Leave Money on the Table
If your company offers 401(k) matching, it's a shame to not take advantage of it. Do your best to understand their program, and even set up a one-on-one meeting with HR if you need help making sense of it. Then, do what you can to meet the matching requirement. If you're company doesn't offer matching, Lapin says you should still inquire about nonmatching contributions. "A match is usually best, but even if your employer doesn't match they might still offer nonmatching contributions based on a percentage of your pay or company profits, especially if your company had a banner year. You won't know until you ask."
Mistake 5: Invest Less Than 10 percent
A typical household needs to save 15 percent of their earnings for retirement, according to a study from The Center for Retirement Research at Boston College [6]. And you don't want to put off hitting that target until you're older and have high out-of-pocket expenses like kids in college. Starting young also gives your money more time to compound [7] in the market. In other words, you can reinvest the money you made off your initial investment and now make earnings on your earnings. It's how the rich get richer.
If you don't believe putting a little more money into your account today will have big returns later, check out this example offered by Nick Holeman, a certified financial planner and financial planning expert at online investing service Betterment [8]. "Someone who puts $4,000 per year into retirement accounts starting at 22 years old can have $1 million by age 62, assuming 8 percent average annual returns. Wait 10 years to start contributing and you'd have to put in more than twice as much – $8,800 per year — to reach the same goal."
Mistake 6: Assume You Can Use It Penalty-Free For a Home
Typically, you can withdraw money early from your 401(k) for a down payment if you have not been previous homeowners in the last two years. But there's a catch, according to Lapin: you can only withdraw $10,000 penalty-free. "That means that you'll be paying an additional 10 percent tax on top of your additional income tax." In other words, if you typically pay 30 percent in income taxes, you will pay 40 percent on whatever you take out for a down payment after $10,000.
Mistake 7: Misunderstand the Implications of Taking a Loan
While you shouldn't take out a loan from your 401(k) [9] if you can avoid it, if it does happen remember that you will owe the money back once you leave your company. "That's true whether or not you're leaving voluntarily," Lapin explains. "It's time to pay up and close out. Or else that loan amount will count as income, and you'll be hit with some hefty withdrawal fees."
Now that you know these common mistakes, log on to your 401(k) account and make sure you haven't made any of them!
