One of the best benefits you can receive as an employee is access to a tax-advantaged retirement plan.
When you contribute to a 401(k) account, you have the chance to get more bang for your retirement buck. However, you might not end up with as much as you’d like if you make a few common mistakes.
Once you open that 401(k), you want to make sure you’re taking full advantage. Here are some 401(k) mistakes to avoid.
1. Missing out on your 401(k) match
Some companies not only sponsor a 401(k) plan, but they also match a portion of employee contributions. In this case, the company is offering you free money, based on how much you contribute each month. The money goes into your 401(k), and it is invested and grows over time, just like your own contributions. Plus, it won’t count against your annual contribution limit.
For example, your company might offer a 50% match, up to an amount that’s 6% of your income. If you make $40,000 per year, that means your company might put in as much as $2,400 per year — or $200 per month. In order to take full advantage, though, you need to contribute $400 per month on your own. Ask your company about their policy and percentage to find out how much you need to put in to max out the match.
Even if you can’t quite max out your total 401(k) contribution — the government allows up to $19,500 for 2021 — you might be able to get the full company match. Run the numbers and see if you can get that extra money from your employer. Over time, thanks to compounding returns, it could make a big difference.
2. Accepting the default savings rate
When you sign up for your company’s 401(k), there might be a default savings rate. For many years, the default savings rate was 3% of a worker’s salary, reports the Society for Human Resource Management. However, according to Fidelity data cited in the report, the median default rate is on the rise to 4% of salary.
Sticking with the default rate, though, might not be in your best interest. The default rate set forth by your plan might not be enough for you to comfortably retire on — especially when you consider that experts commonly recommend that you set aside between 10% and 15% of your income.
Rather than accepting the default rate, consider speaking with your HR department and asking to have more withheld for retirement. If your company offers a match, increasing your rate could also mean more money from the company.
3. Accepting the default investment
In order to take advantage of the compounding returns that come with investing, you need to make sure your 401(k) money is invested in the right fund for you. Some companies have a default investment, such as a specific mutual fund or shares of company stock, meaning your contributions will be invested in the default unless you select a different investment.
Don’t just accept the default investment. Carefully review your investment choices to see if you can add diversity to your portfolio, or if there’s a fund or other investment that will better help you meet your goals. This is especially important if your default is company stock. While having some company stock can make sense, you don’t want all your eggs in one basket.
4. Taking out a 401(k) loan
When you want access to funds, you might be tempted to take a 401(k) loan. After all, you’re borrowing from yourself, right? Any interest you pay gets paid back into the 401(k).
There are some downsides to getting a 401(k) loan, however. First, if you don’t follow the IRS’ rules for 401(k) repayment, the agency can treat it like an early withdrawal and slap you with a penalty.
Next, even though you normally have five years to repay your loan, if you leave your job or are laid off, the entire remaining balance could be due. There are ways to avoid some tax consequences, such as rolling the outstanding balance into an IRA, but it’s important to consult a tax professional.
Finally, even if you are “paying yourself back,” the reality is that there’s no replacing time in the market. You can’t get back the opportunity cost of taking the money out for years at a time.
5. Getting surprised by an early withdrawal penalty
For the most part, the government expects you to keep the money in your 401(k) until you’re at least age 59 ½. If you access your money before then — without going through the process of getting a loan — you could be subject to an additional tax penalty of 10%.
That extra 10% is on top of any other income tax you owe and could represent a significant financial hit.
There are some exceptions to the 10% penalty for early withdrawals, but they are relatively few. Before you withdraw money early from your retirement account, make sure you understand the consequences. You might be better off looking for other solutions.
6. Forgetting about old 401(k) plans
The average person changes jobs 12 times during their lifetime, according to an analysis from job search site Zippia.
As you move through different jobs, there might be old 401(k) plans you’re forgetting about. These plans might be invested in assets that are redundant in your portfolio or might not be helping you reach your goals. On top of that, if you forget about them, you might not access them later.
Review your old jobs and your old 401(k) plans. Consider rolling the funds into your current 401(k) plan to keep everything together, or consider setting up an IRA to receive 401(k) rollovers from old jobs. No matter how you do it, consolidating your 401(k) plans can help you reduce your overall fees and help you better plan your portfolio around your goals.
7. Forgetting to make mandatory withdrawals in retirement
Once you do retire, it’s important to realize that, at some point, the IRS expects you to draw down your 401(k) balance. Starting at age 72, you need to take required minimum distributions (RMDs). Your annual RMD amount depends on the balance of your 401(k) and a formula that determines your life expectancy.
What happens if you don’t take your RMD for the year? Well, you could end up paying a penalty. In fact, it’s a pretty hefty penalty of up to 50% of the amount you were supposed to withdraw. Paying that penalty can be pretty costly for someone living in retirement.
As long as you’re vigilant and stay on top of the situation, though, you can avoid the penalty as well as these other costly 401(k) mistakes.