4 Biggest 401(k) Mistakes

As financial planners and investment advisors, we see mistakes that employees make when handling their 401(k)s.  Four such mistakes standout as having the greatest impact on a comfortable versus not-so comfortable retirement. The good news is that everyone eligible to participate in a 401(k) has the power to avoid these mistakes.

Though we specifically mention 401(k), our observations are the same for 403(b), SEP and any other contributory retirement plans.

Mistake #1: Not Starting Early Enough

This mistake may be the most costly of all.  An employee that begins contributing early to his/her 401(k) has an enormous advantage over someone who waits until retirement is looming.  Consider this: a 25 year old who saves approximately $381 per month to a 401(k) ends up with $1,000,000 by the age of 65.  By waiting until age 45, that same person would need to save over five times that amount, $1920 per month, to end up with $1,000,000 at age 65.  Why?  That’s the power of compounding! 

As a 25 year old, coming up with $381 per month to stash away in a 401(k) may be difficult. The important point is to start early with whatever amount possible.  Just setting aside $100 per month in a 401(k) would provide over $262,000 by age 65.  These assumptions use an average annual return of 7%, which is not a high hurdle for a 40 year investment period.

Mistake #2: Not Saving Enough

As mentioned above, the earlier you start to contribute, the better. Also true, the more you save, the better. In considering the amount to contribute, what many forget is that the dollars contributed to a 401(k), go in “pre-tax”. This means that directing $381 from your paycheck to your 401(k) will not reduce your take home pay by $381, because less income tax is withheld. If our 25 year old is making $40,000 a year and contributing $381 a month to the 401(k), his/her take home pay would see a reduction of only $316. This assumes a 12% federal and 5% state/local tax rate.

Mistake #3: Cashing Out When Changing Jobs

According to the Bureau of Labor Statistics, today’s workers spend on average 4.4 years on the job before moving to another.  It is even less time for the Millennial generation (born 1977 to 1997).  When an employee changes jobs, he/she can rollover a 401(k) balance to an IRA or to the new employer’s plan.  Or, the money can be cashed out.  If it’s a small amount, some may feel it’s not worth the effort to rollover. That is a big mistake!  For example, a $5,000 401(k) growing at 7% would be worth almost $75,000 in 40 years. So cashing out $5,000 from the old 401(k), paying the taxes and penalties, can mean missing out on significant money at retirement.

Mistake #4: Investing Too Conservatively

For most employees, their 401(k) is the biggest investment account they own.  So it is understandable that some would prefer to keep their retirement accounts more conservative.  However, prior to investing your 401(k) think about how long you may need to use the account over your retirement period.  If you plan on retiring at 65, you will need this account to last another 20 to 30 years or more.  If you are only 25 today, you may conceivably have parts of this account invested for 60 to 70 years!  Even at age 45, you will have another 40 to 50 years of investing. With a long investment timeline, you should feel comfortable investing a large portion of your 401(k) in stocks.  Stocks provide the best opportunity for higher returns, especially with a longer term investment period that can ride out the ups and downs.

Summary