Common 401(k) mistakes that you should avoid

Good morning my friend! I thought you would have taken off for summer vacation already, it is already getting so hot!

Helllooo…yes it is getting very warm and a perfect time to go to someplace cooler. I still have a week or so before I fly off to literally chill. What are your plans this summer?

I too will take some time off for vacation in a couple of weeks. It is just not the heat out in the physical world but also how hot the economic world has been that needs some escape. There has been so much fluctuation in the stock market that it is hard to keep up with the why and how of it. I heard that the people that were affected the most were the ones who either just retired or about to retire and saw their 401k accounts fluctuate a lot.

You are right, I also heard about that. The 401k accounts are the only source of major income for a lot of those people and watching that dip would have been extremely distressing. I hope that they had a well balanced portfolio that would not have been stock intensive. This would have at least softened the blow of fluctuations.

Oh that is a good bit of suggestion to make sure your portfolio can survive such major events especially as you approach retirement. I bet someone who had a very aggressive portfolio that was heavily invested in high growth stocks would have suffered the most!

It has been just 2 minutes talking to you and I have already learnt something important! Can you share more tips around what not to do with your 401k accounts?

That is an interesting way to pose the question, instead of asking what to do, you want to know what not to do. I guess that is a good way to avoid mistakes and probably it is a shorter list to remember. I have some quick things that you can use as a checklist to make sure you are not doing those.

But first let’s do a quick 401k recap based on what we talked a while ago [Check out this blog on the different retirement accounts that you must have]. 401k accounts are the most common way of saving for retirement these days as pension plans have begun dwindling. Most employers offer access to 401k plans to encourage employees to save for retirement and employers also get some tax credits for this. Here, you make a selection on how much percentage of your salary to contribute to this account. There is a Traditional and Roth option for 401k accounts, where the former is funded with pre-tax money while the latter used post-tax money. We had talked about which is better and how you can make an informed choice on where to contribute. [Check out this blog on how to decide whether to contribute to a Traditional or a Roth retirement account]

Now let’s go over some things to avoid with 401k accounts – 

1. Not contributing at all to a 401k – We have talked about the different types of retirement accounts and it should be no surprise that they are essential to plan for retirement. The government encourages contribution to these retirement accounts by offering tax advantages. So, the amount of money that can grow in these accounts can be much higher because of these tax advantages. However, despite these advantages 4 in 10 people in the US do not contribute to 401k. Nearly 60% believe they are contributing to  a 401k plan but actually are not. So, you see the first major mistake that is common is not contributing to a 401k account. The amount of money that you can lose if you don’t contribute to a 401k plan can be in millions. The reason you lose a lot is because the money you contribute to this account can be invested in equities or bonds, which can compound growth over a long period of time. 

If let’s say you have a salary of $60k a year and you contribute just 10% of your salary to a 401k account. Based on what age you start, you would end up with different amounts by the time you retire at 65 years of age, but they are all significant sums of money.

If you start when you are 20, with just $6,000/year investment and at 8% rate of return, you would end up with over $2.5 million by the time you are 65.

Let’s say that you start at the age of 30, then that amount will drop down to about $1.1 million. This is a difference of more than over $1 million for delaying investing by 10 years.

If you delay another 10 years and start investing when you are 40, then you will not become a millionaire and end up with about $480k.

You can see how delaying investing with a relatively small amount of contributions every year can cost you so much. Therefore, if you are not already contributing to your 401k account, you should start ASAP. If you are not sure if you are already contributing to one, contact your HR and they can assist in answering that question.

Wow, those numbers are staggering! We are talking about millions of dollars here which is a huge sum of money. After our first conversation on retirement accounts, I ensured some part of my salary was going to the 401k retirement account. But this is a good check to have in place because of how important it is in terms of the amount of money we are talking about here. I am excited to learn more.

2. Not contributing enough to get full 401k match – The second thing that you can check is if you are availing the contribution match offered by your employer. A contribution match is basically the employer contributing money to your retirement account based on how much money you contribute. For example, an employer may offer a 100% match up to 3% contribution of your salary. This means that if 3% of the $60k salary is contributed i.e. $1,800, then the employer will do a 100% match that will contribute the same amount of $1,800k. This means effectively you are contributing 6% of your salary instead of just 3% that you signed up for. Another way to see this is from a rate of return point of view, you are getting a 100% return on your investment because for every dollar you contribute up to the limit you are earning another dollar. This is one of the highest guaranteed rates of return you will ever get in any of the assets that are currently available. Do you see how good this is? Even though this is such an attractive prospect, nearly  22% of Americans don’t contribute enough to get the complete 401k match. If you want to look at how much just 1% lower contribution amount can cost you, let’s continue our example. Instead of 3% contribution to get the complete match, if only 2% is contributed then you only get the match for the 2%. So, you lose $600 every year from the employer match. This seemingly small contribution every year that you lose would cost you over $250k over a 45 year investing period till retirement.

Sometimes it is confusing to understand the terms and conditions of an employer match and know if you are contributing enough to make the most of the match. So, a good strategy is to contact your HR department or the department that deals with retirement benefits and make sure that you are maxing out the employer match.

I am convinced that the 401k match that the employers offer is the closest we can get to free money. It is a no-brainer that if you have decided to contribute to a 401k retirement account then it is best to avail the 401k match. I will definitely go back and check if I am getting the maximum employer match that is possible. What is the next point on the checklist?

I would say the first two are the most important ones to avoid.

3. Cashing out your old 401k or taking out loans on your 401k account – The third one is only possible if you avoid the first two successfully. When you change jobs then you get to decide what to do with your 401k. Do you want to roll it over to your new 401k plan at the current employer or cash out and use it for something else. 

Unfortunately, a lot of people decide to cash out the money from their old 401k.  41% cash out some part of their old 401k and 85% of those 41% cash out their entire 401k. Younger people are more likely to cash out since they think the amount is insignificant. This is bad because you lose out on the time the money had to grow and now that money is going to be used towards assets that don’t grow.

The farther you are away from retirement, the more amount of money you will lose if you decide to cash out instead of rolling it over to the new 401k account. Also, even if a small portion is cashed out that could still cost you millions of dollars based on the time you have till retirement, so no amount is too small.

Also, along the lines of cashing out the money from 401k for other purposes, is the mistake of taking out loans on your 401k account. You are basically taking a loan by borrowing from your future self which might seem better than borrowing from a lender. However, you end up getting a higher interest loan which would have to be repaid in full within 60 days of you losing employment. Both these issues make it a risky move to borrow from your 401k account. Also, you lose out on the compounding growth because your contributions go towards paying down the interest of the loan rather than investing in assets.

That is a really important insight of managing the 401k account while changing jobs. I had no idea what happens to the 401k account when one changes their jobs. Good to know that there are some important decisions that need to be made then. I do not have any plans to change jobs in the future but whenever I do or I am forced to do, I will keep this point in mind. Also, I would never have guessed the option of borrowing from the 401k account. It is good to know that there is even an option to do that but knowing what you just told me I would avoid it at all costs. I can sense you have more to tell, so what are the other things to avoid?

4. Not investing the money in your 401k account – You should avoid the mistake of not investing the money you have in your 401k account or any retirement account for that matter. It is no secret that the major benefit of the retirement account comes from the ability of the investments in the 401k account to grow with the benefit of compounding. The higher the rate of compounded growth, the faster your money will grow and benefit by the longer you keep it invested. The rate of compounded growth depends on the type of assets that you invest in. For example, you can invest in index funds that track the S&P500 i.e. the largest 500 companies in the US in terms of their market capitalization. This index fund on an average gives a 10% rate of return on an average based on past 50 years of performance. You could also choose to invest in other funds or not invest at all. Keeping all your money in 401k as cash would earn a 2% rate of return, which is significantly lower. The only benefit of keeping your money as cash would be to avoid any major fluctuations in the portfolio value when there are major economic events like the ones happening these days. This is definitely a very safe strategy but one that will not earn a good rate of return. History has shown us that the index funds that track the overall market may have fluctuations in the short term but over the long term they are pretty reliable in generating higher rate of returns than simple cash funds. So, if you are someone who is far away from retirement, like more than 10-15 years then any fluctuations that you see now will get dissipated over time and your investment might not suffer. Of course there is risk involved and past performance is not a guarantee of future returns, bit that is where a balanced portfolio comes in handy. You can have some amount of your portfolio in relatively risky assets like stocks and some of it in bonds and cash. Such that this portfolio can earn a decent rate of return that can beat inflation and maintain, if not increase, your purchasing power during the retirement period.

Thank you for sharing that! I will be sure to check my portfolio and since I have a lot of time before I retire, I might be a bit more aggressive in selecting the assets. Over time I will change to a more conservative portfolio that will not fluctuate a lot. Overall, this was a very fruitful discussion for me because I learnt a lot! Have a good vacation!