If you are saving for retirement, like many Americans, your main vehicle to do so is probably some form of defined contribution plan such as a 401(k) or 403(b) plan. The problem is the average American is not saving enough and many are making common and basic mistakes with their employer sponsored retirement accounts.¹ Here are some tips that will help prevent you from derailing your retirement.
#1 PARTICIPATE AND CONTRIBUTE TO MATCH
The first and obvious pitfall to avoid is simply not participating in your company’s defined contribution plan. Four out of five American workers are employed by a company that offers a defined contribution retirement plan, but only 32% or workers are utilizing them.² Not only are they not taking advantage of the tax benefits, they are walking away from free money. Many employees offer an employee match (generally on average) of 50 cents on the dollar on up to 6% of contributions. To save an adequate amount for retirement, you should be contributing at least 15%. For those who cannot afford that much, make elective contribution deferrals to at least the employer match so you’re not missing out on the free retirement savings.
#2 LOANS VS. WITHDRAWALS
When faced with unexpected financial crisis, it’s tempting to tap into your 401(k), but doing so could put your retirement at risk by missing out on the compounded interest you would earn over years. Not to mention you would have to pay the IRS a 10% premature withdrawal penalty if you are under 59½ years old. The alternative, but not much better option, is taking a loan from your 401(k). Some plans offer a loan provision, which allows you to borrow from your fully vested funds. The loan is repaid to yourself/your 401(k) plan, with interest. Approximately one in five workers who participate in an employer-sponsored defined contribution plan has taken a loan from the plan’s balance. The pitfall participants can run into when taking a 401(k) loan, is leaving or getting fired before paying back the entire loan balance. If that happens, the full amount of the loan comes due and if not paid back, the remaining amount becomes a taxable distribution.
#3 VESTING (DON’T TURN YOUR BACK ON FREE!)
401(k)/403(b) vesting is when an employer makes a matching contribution on your behalf into a defined contribution plan, but does not give you complete ownership of those funds until you have met certain requirements. For example; the typical vesting schedule is 25% vested after one year, 50% vested after two years, and 100% vested after three years. Vesting schedules can vary based on the respective employer’s plan. Retirement savings plan vesting schedules are a common way for employers to provide a motivation for employees to stay with the company for at least a few years.
If you are thinking about leaving your job, first find out:
- How much of your 401(k)/403(b) is vested?
- How much time is left for it to be fully vested?
If you’re only a few months away from being vested, perhaps you should stick it out a bit longer until you are. You could be walking away from free money.
#4 TAX DIVERSIFICATION (ROTH 401K OPTION)
If you automatically get enrolled into your company’s 401(k), by default, you will most likely be enrolled in a traditional plan. One common mistake that 401(k) investors make is not learning if the plan has a Roth 401(k) option. A Roth 401(k) is exactly like a Roth IRA in the sense that you can take a portion of your taxed income and invest it so it grows tax free and can be withdrawn tax free, only with a much higher contribution limit. The IRS allows for up to $5500 a year contribution ($6500 if you are 50 years old or more) to Roth IRAs and up to $18,000 ($24,000 if you are 50 years old or more) for Roth 401(k)’s.
A better approach might be utilizing both the traditional 401(k) and Roth 401(k), so during retirement you have access to one bucket of savings that will be taxed when withdrawn and another bucket of savings that will not be taxed.
The only down side to the Roth 401(k) is that it does not reduce your taxable income like the traditional 401(k) does, so ask a financial advisor which situation might suit you the best.
1. Steverman, Ben. “Two-Thirds of Americans Aren’t Putting Money in Their 401(k).” Bloomberg.com, Bloomberg, 21 Feb. 2017, www.bloomberg.com/news/articles/2017-02-21/two-thirds-of-americansaren-t-putting-money-in-their-401-k.
2. According to research conducted by AonHewitt in 2012. Powell, Robert. “7 Worst 401(k) Mistakes by Retirement Savers.” 8 Mar. 2014, www.marketwatch.com/story/7-worst-401k-mistakes-by-retirementsavers-2014-03-08.