Thanks to a nearly ten-year bull market, 401(k) account balances are at record highs, providing future retirees with a more optimistic retirement outlook. However, through negligence or a lack of understanding of how their 401(k) plans work, many plan participants may be making some very costly mistakes that could leave a lot of money on the table. With your financial security at stake, it would be important to spend time learning what not to do and how to make smart moves with your retirement savings.
Here are the most common 401(k) mistakes that could cost you:
Not everyone is in a position to be able to contribute the maximum of 15% of their salary to retirement savings. But, for many people, their contribution amount is a function of what they have left over after spending money on meals out, expensive clothes, new cars, extravagant vacations or the latest tech gadgets.
For anyone with aspirations of building wealth, time is your most valuable asset. Most people start out with little money, a lot of time and a similar opportunity to build wealth. However, each day that passes without some contribution of money – either savings or interest – the cost of achieving our financial goals increases. It’s why many people at or near retirement, who will never get that time back, wished they had saved early and often.
Even if you are struggling to contribute regularly to your 401(k), you’re making a huge mistake if you’re not taking advantage of an employer match. Most employers offer some form of a matching contribution, which is essentially free money and a guaranteed return on your investment. A typical employer match might consist of a 50% contribution up to 6% of your salary. If you earn $70,000 and contribute at least 6% ($4,200), the match will increase your contribution by $2,100. Forgoing that match by not contributing enough is like losing $2,100 a year. Who can afford that?
Find out what you need to contribute to take full advantage of your employer’s matching contributions and then trim your spending as necessary to free up the money you need for the contribution.
Regardless of how much you are contributing today, you should increase your contributions regularly until you are saving as much as you need to or until you reach the maximum yearly contribution level ($19,000 in 2019, $25,000 if 50 or older). According to Fidelity Investments, by merely increasing your contribution by 1% every year for 12 years, you would increase your monthly income in retirement by $1,930 (pre-tax).* That’s $23,160 a year you leave on the table by not increasing your contributions by just 1% a year.
Many plan participants simply choose their plan’s default options for investments. These tend to be very conservative options, like target-date funds. Or, the idea of stock market volatility may not be appealing so they overweight their fund allocation to bonds or money markets. The danger is, for whatever peace-of-mind safe investments may provide right now, you risk a significant loss in purchasing power when you need it most in retirement.
For people with retirement time horizons of 15 years or more, the stock market provides the best chance of not outliving your assets. Over the last one hundred years, the historical return for stocks has been 8.1% as compared to 5.1% for bonds. Both compare much more favorably than the average return on cash equivalents (CDs, savings, money markets), which are well below 3%. While it’s always advisable to allocate your money among several different asset classes to reduce volatility, younger people should consider over weighting their stock allocation to take advantage of the time they have to let the market cycle through its ups and downs.
Among the more scrutinized aspects of 401(k) plans has been the fees they charge plan participants. That’s because, when it comes to long-term investment performance, fees do matter. Consider the following example of the impact of fees on the growth of $100,000 invested over 30 years:
Plan sponsors are under a fiduciary obligation to ensure that plan participants are charged reasonable fees. However, account and administrative fees can range from as low as 0.10% to as high as 3.5% — per year. To a certain extent, you can control the amount in fees you pay each year by carefully examining the prospectuses of the funds you choose.
More actively managed funds – in which the fund manager buys and sells securities in an attempt to increase the fund’s return – tend to charge higher fees. Passively managed index funds – which invest in a static index with very little buying and selling – charge much less. Interestingly, the data shows that index funds have performed as well or better than active funds over the last couple of decades due in large part to the lower fees they charge.
Since their inception, 401(k) plans have been a boon for retirement savers. Their easy access, automatic savings feature, and tax advantages revolutionized the way people save for retirement. However, 401(k) plans are not perfect and understanding their limitations may help you improve your retirement savings.
For example, most 401(k) plans have limited investment options – typically between a dozen and several dozen mutual funds. While you should be able to create a reasonable asset allocation from that selection of funds, you are still limiting your options, which could include index funds or exchange-traded funds (ETFs) if you were to invest in an Individual Retirement Account (IRA).
Also, the fees charged in 401(k) plans can be high. In addition to the investment management fees charged by the funds, you also pay administrative fees charged by the plan sponsor. As shown in the example above, a difference of just 1% in fees charged can translate into more than $100,000 over a 30-year time horizon.
Taxes may be another limitation. While you may enjoy current benefits from before-tax contributions and tax-deferred earnings, you will have to pay taxes at your ordinary income tax rate when you withdraw the funds. For some retirees that can push them into higher tax brackets where as much as 85% of their social security benefits are taxed. Knowing what they know now in terms of retirement income taxation, many retirees would probably have chosen a different accumulation strategy that included allocating more of their retirement contributions among post-tax accounts that generate tax-favored capital gains or a Roth IRA for its tax-free withdrawals.
Make no mistake, 401(k) plans are an essential and powerful retirement savings tool. However, your plan is but one component of an overall financial strategy that needs to consider your pre-retirement and post-retirement objectives along with the tax implications that can impact both. To achieve the optimum outcome from your retirement savings efforts, you should meet with your financial advisor to ensure your plan is properly integrated with your overall financial plan.
*Assumes the individual saves until age 67, lives through age 93, and generates a rate of return of 5.5%.