You and your 401(k)
When it comes to your 401(k), the employer match is essentially free money. Saving for retirement can feel daunting, but maximizing your 401(k) doesn't have to be. Here are some avoidable mistakes and how you can ensure that your nest egg grows steadily.
NOTE: 401(k) plan rules vary by employer. This post includes advice based on plans I have encountered; however, please verify with your plan rules to confirm if the assumptions below are applicable.Things not to do with your 401(k)
Miss the match: Be sure to review your contribution so that you get the entire match (all the free money). For example, if your organization matches 100% of your first 4% of pay, make sure you contribute at least 4% of your pay each month.
Default it and forget it: Based on your 401(k) plan rules, if you don't select an investment, the company may send your contribution to the default investment, a money market fund, or worse, a cash account that makes less than your savings account. After signing up for your plan, log in to your account and select investments for your future contributions. Based on your level of investment knowledge, the investment options to consider may include a Target Date fund, the S&P 500 Index, the Total Stock Market Index, and others. There is a wealth of information available online about selecting investments. My recommendation is to start with a low-cost index fund for now, and then, as you learn, begin diversifying into different asset classes.
Ignore fees: All investments have fees! Be sure to understand the costs associated with the investment, as well as the fees for maintaining the account. Never choose investments with front-end loads. Here is a post on fees and what to avoid
Wait until you feel you have extra money: Don't wait! The sooner you start contributing, the longer that money can grow. Based on your spending plan, determine the contribution level that best suits your needs. Not sure what is possible? Start by setting the employer match percentage, and then increase your contribution each month by 1% until it aligns with your spending plan. Shoot for 5 – 8%. Once you find your level, set up your contribution to automatically increase by 1% or 2% each year, or whenever you receive a pay increase. You will barely notice the increased contribution, and it will help build your nest egg with little impact on your lifestyle.
Focus solely on investing in your 401(k): The 401(k) is a valuable tool for saving for retirement. But there are other tax-advantaged accounts that you can use for specific saving vehicles, a 529 for education expenses, a Health Savings Account for medical expenses, an after-tax brokerage account for money you want to invest and use before 59 ½. Review online educational resources that recommend the order in which to contribute to each of these accounts. I believe it is a personal choice, so be sure the allocation you choose matches your goals.
Skip it: Some companies won't match your 401 (k) contributions. If your company doesn't match your contribution, simply not using it isn't always the best idea. Consider investing in the Roth 401 (k) option. A Roth 401(k) contribution limit is significantly higher than a typical Roth IRA, so take advantage of this higher limit instead. Also, consider the behavioral aspect; automated investing is easy and may help you save more, as you don't have to actively manage your money each month.
More advanced things not to do with your 401(k)
Take out a Loan – I have used it in the past to pay off some debt, but I focused on keeping it short-term. In the long run, a 401 (k) loan can hurt more than it helps. This should be the last resort for a loan. The downsides of this loan include:
Your money is out of the market – while you pay back the loan, your money is out of the market, missing potential investment growth.
You will repay the loan with after-tax dollars, and then when you withdraw it in retirement, you will pay taxes again on that portion. This is a form of double taxation.
If you lose your job, you will have to pay it back quickly or risk it being treated as a distribution (where taxes and penalties may apply).
Put it all in too soon: For those who max out their 401(k), make sure to spread contributions throughout the year. Check your plan for guidelines, as many plans are billed monthly. If you max out too soon, you may lose the match in those months you didn't contribute. For example, if your plan matches 100% for the first 4% of the monthly contribution, you contribute 10% monthly, and max out in 6 months. For the first 6 months, you get 100% match on the first 4% you contribute. However, for the last six months, if you didn't contribute, you will not receive a match. You lose 4% x 6 months.
Distribute Early – In-service distributions, if permitted by your plan, can have a significant impact on your tax picture. Tread carefully and consult with an accountant to confirm you aren't digging a tax hole.
Roth 401(k) - Unlike Roth IRAs, Roth 401(k)s don't allow easy access to contributions. Review your plan rules for tax impacts.
Traditional 401(k) - Any distribution before 59 ½ will incur taxes and penalties. You will pay such a heavy price for any early distribution that it won't be worth it.
If you accidentally distribute funds and don't want to incur those taxes, you must deposit the distribution into an IRA within 60 days. This is called a rollover, and rollovers don’t incur any tax or penalties.
So, each year, take 15 minutes to review your 401(k) or work retirement plan and ensure you aren’t making any of the mistakes above. Ultimately, you are the only one responsible for your financial decisions; take that responsibility seriously at all stages of your financial journey.