Common 401K Mistakes You can Easily Avoid
You just got a new job or a promotion. Or you just completed your one year anniversary that makes you eligible for additional benefits offered by your employer. Take advantage of everything they have to offer – and especially take advantage of any qualified retirement plans offered – such as a 401K plan – unless you’re counting on winning the lottery – in which case you could stop reading here.
The IRS generally requires employees to be allowed to participate in a company-sponsored qualified retirement plan if they have at least one year of service and are at least 21 years old. There could be other factors and it depends on the specifics of the plan, but for the most part those are the most common minimum requirements.
Unfortunately, many employees fail to take advantage of this benefit and either forget, ignore, and otherwise miss out on the financial benefits that 401K plans provide. Don’t be one of these people. The biggest issue is that time is one of those things we can never get back and every year that passes without you optimizing the benefits you can get from your 401K plan is a year you can never make up.
Here are some of the most common mistakes to consider:
Mistake: Many employees don’t participate in their 401K plans even when they are eligible
Some plans now require mandatory enrollment and you must voluntarily opt-out if you would prefer not to participate. But not all plans have the mandatory enrollment feature which means you must actively choose to participate to have a portion of your check deposited into your plan on a regular basis. Arguably the biggest mistake most folks make is not participating at all. I get it. You just got a new job and want all of your paycheck to flow into your pocket. The problem is that once the calendar year is over, you lose the ability to contribute that year – forever. And investing early and often pays off in the long run.
What to do: When starting a new job, make sure you understand when you become eligible for participating in the company’s 401K plan. If it requires one year of service, put it in your calendar even if your company will likely remind you about the plan again during open enrollment – especially if you have highly competent human resources professionals. If you are eligible immediately, sign up, make the biggest contribution you can afford, and make sure you understand how the contributions will be invested. If you’re not sure, ask for help from your 401K rep or your financial advisor, if you have one.
Mistake: Some employees don’t contribute because the company doesn’t provide a match
This mistake is obviously related to the first one. But the reason for not participating is specifically because the company doesn’t provide a match. That you’re not participating is a mistake, in my opinion. That you’re not participating because your company doesn’t provide a match is stupid. Your company is paying you a salary, providing medical and other benefits, and hopefully providing you with stimulating work in an engaging environment. That they don’t contribute to your retirement might be an issue for them when faced with competition for employees, but it is your responsibility to plan and prepare for your financial future.
What to Do: If your company does provide a match, that’s an added benefit, but the tax benefits you get from contributing yourself and the tax-deferred growth you can achieve by investing in a retirement plan should be enough for you to participate.
If your employer does contribute, then they have just given you a guideline for the minimum you should be contributing. The amount you should be contributing is the amount that gets you the maximum contribution from your employer. A typical feature is a company matching 50% of your contribution up to 3% of your salary. That means that to get the full 3% from your company, you have to contribute 6% of your salary. Done. Pick your investments and move on. Why not get ‘free’ money from your employer?
Mistake: Some employees contribute to the 401K plan but then don’t invest the funds
Just because you opted to contribute doesn’t mean your contributions are working for you. In many cases, companies have a default investment that might be a target-date fund that coincides with your age. While this is not always ideal, it is better than having cash sitting in an account that is not generating returns for you. In order to get the full benefit of investments in a retirement account, the funds need to be properly invested.
Target date funds forecast your retirement date based on your age – investing in asset allocations that correspond with the remaining time to retirement. The younger you are, the more aggressive the fund will be invested, typically by allocating a greater share to equities. As you age, the fund automatically shifts investments into more conservative positions so that there is less risk as you approach retirement.
At a minimum, make sure the funds are invested in a target date fund, but the better option is to choose investments that provide you with the investment objectives that are unique to you while staying within your risk tolerance.
You likely have more than 15 funds to choose from and this might cause analysis paralysis. What funds should you choose? How much should you invest in each? Do you pick US or International Stocks? You can get so overwhelmed you don’t make a decision and set it aside for another day. Then time passes and you forget that your retirement funds are sitting in cash while the markets are booming. Ouch!
What to do: Make it a priority to invest your funds. If you fall into the paralysis by analysis funk, get someone to help you. Your HR person should have a contact person at your plan administrator that could give you guidance.
Mistake: Some employees contribute and invest the funds BUT they don’t invest it appropriately
Not investing is bad enough, but not investing the funds appropriately can be just as bad. This is probably why most of you make the previous mistake of not investing. You’re afraid of making a mistake. Investing too aggressively could result in higher than expected volatility and higher levels of stress. On the other hand, investing too conservatively could result in lower long-term returns and lead to not reaching financial goals. Either one results in returns that do not meet expectations.
What to do: I suggest taking the time to figure out how you should be invested based on your specific goals and personality. We have created an Investment Questionnaire that guides you on how your portfolio should be positioned. I always recommend that clients redo the questionnaire at least annually, and especially when you have had a high number of life-changing events. Send me a quick note and I will send it to you. Aneto(at)netofinancial.com.
Mistake: Some employees invest the funds and invest correctly, but then they don’t monitor the investments on a regular basis
Some employees contribute to their retirement plan right away and either find help figuring out how best to choose the investments or have some basic knowledge of how to allocate to the investment options available in the plan. Unfortunately, they stop there. Over time, however, investments ebb and flow and some investments grow faster than others, resulting in a different allocation than what you intended. Most retirement plans don’t rebalance the funds automatically which means that over the years, the retirement funds could once again be invested inappropriately because of how the balances of each fund have changed over time.
What to do: At least once a year and quarterly would be even better, you should be taking a peek at your investments and make sure the percentages allocated to each fund are still in line with the plan you put in place. If your goals change, that’s OK – change the allocations. But if your goals haven’t changed, make sure to rebalance the funds to the original percentages.
Mistake: When employees get a raise, they fail to increase contributions to their plans
You got a new job and you are contributing a nominal amount to your retirement plan. Your employer provides a match for up to 3% of your salary and now a year later, you get a raise of $5K annually. You’ve grown accustomed to living with your previous salary and despite having some plans for the extra money, you never consider increasing your contributions to your retirement plan. You’re nowhere near the annual IRS limit so why not increase your contribution? The tax benefits of retirement plans means that for every dollar you contribute will result in less than a $1 reduction in your paycheck. For every dollar you contribute you really only reduce your paycheck by about 20% or so, depending on your tax rate. Here’s another benefit, the increase in your contribution also increases your employer’s contribution!! More free money!!
What to look for?
Here are the important events to look for when it comes to your retirement plan:
1. Start date – act immediately to participate in your 401K or set a calendar reminder for when you are eligible.
2. Anniversary – on your first anniversary and every year thereafter, take a peek at your 401K and make sure it’s invested as it should be.
3. Pay Raises – pay yourself first by putting some portion of your pay raise into your retirement plan. This is another good time to evaluate how it is invested.
4. Promotions – this usually comes with a pay increase. See previous bullet point.
If you’ve recently reached some of these milestones or see one of them on the horizon, start looking at how you could maximize the benefits you get from your 401K. It’s your retirement, take control of it.