Defined contribution 401(k) plans are some of the best deals available to working Americans saving for retirement. The contribution limits are generous; you can contribute up to $20,500 in 2022, with a $6,500 additional catch-up savings if you’re 50 or older. Many companies offer a matching contribution, which can be up to 6 percent of employee salary pre-tax.
To top all that off, 401(k) plans possess significant tax advantages. Contributions are taken out pre-tax, so you don’t pay taxes on the amount you are contributing. That bite out of your salary has the potential to lower your overall tax bill in the contributing year. The money grows tax-deferred until you withdraw it.
It may seem like you can’t go wrong by participating in a 401(k), because of all these aggregate advantages. However, it is possible to make mistakes with a 401(k). We see these mistakes especially when managing your own 401(k). Why? Individuals who aren’t in the financial services industry typically do not know all the ins and outs of these great retirement savings vehicles. Like any investment or retirement plan, a 401(k) should be managed toward a goal and be actively reviewed on a periodic basis.
At Scarborough Capital Management, we specialize in 401(k) plan management. Below are 5 common mistakes we see DIYers make with their 401(k)s – and how to avoid them.
Need help with your 401(k)? Contact Scarborough Capital Management to see how we can help.
Mistake #1: Not Knowing Your Retirement Needs
You should have a plan for how much you will financially need in retirement. Otherwise, you have no way of knowing whether your retirement savings are on target or falling short. Planning without a goal is like trying to formulate a financial plan for your life currently, but without any sense of how much cash flow you need every month.
But how can you possibly know what you’ll need in retirement, especially if you’re still decades from retiring? Prices will be different – likely higher, due to the unstoppable march of inflation. In fact, it’s prudent to factor in inflation into your projection of expenses, especially for costs such as healthcare. Historically, inflation has risen at roughly 3 percent annually.
Here are 2 things you can do:
First, define your retirement goals. Would you like to live at the beach? Relocate to be near grandchildren? Travel? Launch a business? It’s likely you have some idea of what you’d like to do. You can always revise these goals, but it’s important to have a sense of what you’d like your life to be like.
Second, project your current budget forward and modify it for your retirement plans. If your current mortgage is likely to be paid off, for instance, eliminate the mortgage payment but keep property and other relevant taxes. If you will still be paying a mortgage in retirement, keep it as part of your budget. Separate fixed expenses, such as food and utilities, from non-fixed expenses, such as vacation funds.
While the budget will not have pinpoint accuracy if you are years from retirement, it provides a benchmark to let you know if your 401(k) and other retirement savings are enough. These estimates can be complicated, so it’s a good idea to work with a financial advisor in developing them, especially one who specializes in 401(k) management when you are currently managing your own 401(k).
Mistake #2: Not Saving Enough
One of the beauties of 401(k) plans is their ability to grow over the years. A 35-year-old who contributes $19,000 annually ($1,583 monthly) over a 30-year period will have $1.32 million to retire with at age 65, assuming a yearly 5 percent return. Check out NerdWallet’s Investment Return Calculator to see how your savings could grow.
But in fact, most Americans aren’t saving enough for retirement. Research by the Federal Reserve found that the median retirement account balance in the U.S. was just $65,000. Assuming a 4 percent annual withdrawal, $65,000 would provide retirees with $2,600 per year throughout their retirement, or just over $216 per month. That’s very unlikely to be enough for a comfortable retirement, even factoring in Social Security.
In addition, of course, not saving enough to receive a maximum match if your employer offers one is leaving money on the table. If you make $60,000 per year and you contribute 6 percent, you are saving $3,600 for retirement. If your employer offers a 100 percent match, your yearly retirement savings doubles, to $7,200. If you don’t participate at all, you’re losing the employer’s potential contribution entirely.
Taking advantage of an employer match may sound like common sense, but millions of people don’t.
Mistake #3: Never Reviewing Your Plan
It’s wise to review your entire retirement plan at least once per year.
First, review your retirement plans and goals. Are they still the same? Have they changed? Have any life changes occurred that could affect your retirement? Marriages, births and divorces are just some of the potential changes that could have an impact.
Second, your retirement funds may need to be rebalanced to make sure that your investment strategies are still in line with your goals. Some investments have greater appreciation potential, but also carry greater fluctuation risk. Other investments may have more stability, but less appreciation potential. If you don’t rebalance, you can end up with a portfolio over-weighted in positions that are subject to volatility, and thus carrying more risk than is prudent.
As a rule of thumb, your retirement portfolio should also become more conservative as you age, so that you aren’t heavily weighted in more aggressive positions as you approach retirement. A stock market correction of 20 percent or more could hinder your retirement plans or cause a delay in them.
Mistake #4: Not Considering Fees
While nearly all retirement funds charge fees, there is no standard fee. Fees that are too high will siphon off your retirement funds. It may not sound like much, but even a 2 percent fee takes $410 from a $20,500 contribution every year. Over 10 years, that becomes $4,100 you don’t have invested.
The fine print provided on your 401(k) plan should provide information on the fees charged on investments. If they are too high, consider switching investments to reduce the costs. Another strategy is to contribute as much to your 401(k) as necessary to get the maximum employer match.
Mistake #5: Cashing Out Too Early
Because 401(k) funds can seem hefty, it can be very tempting to cash them out, especially for large purchases such as a house or a car. A lot of people do this.
But it’s a poor strategy for retirement savings. Withdrawing early can result in penalties as well as income tax on the amount withdrawn if you withdraw money from your 401(k) before the age of 59-½.
Even more importantly, perhaps, is that the money withdrawn will no longer grow tax-deferred toward your retirement. Leakage, as financial experts call early withdrawals, can curtail your overall retirement nest egg both in the short and long term.
Worried that you’re making mistakes with your 401(k)? Talk with a financial advisor who specializes in 401(k) plan management to make sure you reap all the benefits of your 401(k) and avoid the pitfalls.
