[BUSINESS] 401(k) flubs - 5 to avoid
- Mistake 1: Not participating in your 401(k)
If you're like a lot of workers you won't have a defined benefit
pension coming to you in retirement, and living on Social Security
alone means you'll be cutting it pretty close to the bone.
So, unless you're angling to live like Mother Theresa minus the
selflessness and international acclaim, you should take advantage of
your 401(k), which offers you free money, tax breaks and a very
convenient way to build your nest egg.
Any contributions you make will reduce your taxable income for the
year and will grow tax-deferred until retirement. Plus, many
employers will match a portion of your savings. And that extra dollop
of money is tax-free to you.
The sooner you start, the better, since you won't have to save nearly
as much of your salary to reach your goals if you start young than if
you start in your 40s or 50s. (Not that all is lost if you get
started late, it just takes a lot more discipline, as Walter
Call your benefits office to find out how to sign up for your 401(k).
The task may soon be made easier for employees as more companies are
adding an auto enrollment feature. Here's how it works: as soon as
you are eligible to participate in the company's 401(k), a small
percentage of your pay is automatically deducted and put in a 401(k)
account. You are free, however, to change your contribution level and
Mistake 2: Not contributing enough
How your investments perform is a big factor in whether you'll have
enough money to retire. But the biggest factor is how much you
As Money Magazine's Penelope Wang points out, suppose you started
work in 1990 with a $40,000 salary. You saved just 2 percent of your
pay and invested in the top-returning funds every year. You would
have finished 2005 with nearly $50,000.
By contrast, if you picked mediocre funds every year but were frugal
enough to save a full 6 percent of your salary, you'd end up with
There's another reason to contribute more than a paltry 2 percent.
You want to contribute enough to get the full match offered by your
employer. If you have no problem turning down free money, you might
want spend a few bucks to ask a therapist why.
Fidelity has a calculator that will show how your contributions will
affect your take-home pay.
If you can't afford to max out your contributions, at least
contribute enough to get the full match from your employer. (So if
the boss offers to kick in 50 cents on the dollar up to 6 percent of
your pay, contribute at least 6 percent of your pay.) Then boost your
annual contributions by one to two percentage points every year. A
little goes a long way.
Mistake 3: Not investing for growth
According to the latest data from the Investment Company Institute
and the Employee Benefit Research Institute, nearly 19 percent of
workers in their 20s are not investing any of their 401(k) money in
stocks, while another 16 percent have less than 60 percent in stocks.
The allocation for those in their 30s isn't much better. Thirteen
percent had none of their 401(k) balances in stocks while 17.5
percent had less than 60 percent.
Being too conservative in your investments, especially at a young
age, is a very costly decision.
Take a 25-year-old making $40,000 a year with $5,000 saved. And say
she now invests $500 a month. By age 65, she'll have $1.4 million if
she invests only 20 percent of her money in stocks and the rest in
bonds and cash, according to Fidelity's new retirement planner. But
if she puts 85 percent of her money in stocks, she'd have close to $2
million. That assumes average market performance.
Try Fidelity's easy 5-question myPlan calculator to see what a
difference it will make to your nest egg if you increase your risk
tolerance and/or boost your monthly savings. When filling in how much
you save a month, don't forget to add in the amount of money you get
in matching contributions from your employer.
And for a quick sense of the best allocation for you given your time
horizon and risk tolerance, use CNNMoney.com's "Fix Your Mix"
calculator to the right.
If you're not interested in allocating your own portfolio, consider
investing in a target-date retirement fund, which allocates your
money for you in accordance with your time horizon until retirement.
(Learn more about these funds.)
If you really can't stomach risk, then you'll need to significantly
increase your savings to get the same result.
Mistake 4: Borrowing from your 401(k)
Borrowing from your 401(k) should be a last-resort measure for
important expenses such as medical bills or, in some instances, to
help buy a home if that makes financial sense.
You shouldn't tap your 401(k) for expenses such as cars, vacations,
weddings or other big-ticket items that are all about diminishing
Here's why: You will be on the hook to pay yourself back with
interest, and by taking a chunk of your retirement money out for some
period of time, you forfeit the growth that could have occurred on
that money plus the money left in the account. A larger balance can
compound faster than a smaller one.
Plus, if you leave your company while the loan is outstanding, you
may be asked to pay it back as soon as you leave or soon after.
Otherwise, the money will be treated as a distribution, subject to
income tax and possibly a 10 percent early withdrawal penalty.
If you really need money, you first should try to find a competitive
rate on a personal loan or home equity line of credit before
considering your 401(k) as an option. (See how a 401(k) loan might
stack up against a home equity line of credit.)
If you need to tap your 401(k) for a critical expense and have no
other option, budget for the smaller paycheck you'll receive since
your employer will automatically deduct the loan payments from your
check. The last thing you'll need is to incur any further debt by
spending more than you take home.
Mistake 5: Cashing out your 401(k)
You want to keep your 401(k) money invested at all times, even when
you change jobs. Telling yourself you'll take the money with you and
will reinvest it later is a recipe for big bills.
As the graphic at right shows, cashing out your 401(k) will suck a
lot out of your hard-earned savings. Your money will be taxed as
income the year you withdraw it. You may be subject to a 10 percent
early-withdrawal penalty. And you'll lose out on a lot of growth that
could have occurred if you hadn't cashed out.
When you leave a company you typically have three options:
Roll your 401(k) balance into a retirement plan at your new employer,
assuming the new employer has agreed to accept the money into its
Roll your 401(k) balance into an IRA if you want access to a broader
universe of investments than your employers' retirement plans offer.
Leave the money in your old employer's 401(k) plan (unless your
balance is under $5,000)
If you choose to roll the money over, the smartest and easiest way to
do so is what's known as a direct rollover or trustee-to-trustee
transfer. That means you never handle the money. Rather you tell your
401(k) provider to send the check to the company housing your new IRA
(Money Magazine's Walter Updegrave has tips on how to decide whether
to roll your 401(k) into an IRA or your new company's retirement