Just a few years ago, I was a financial advisor helping people with their investments. One area of concern for many people were their 401(k) plans.
There are numerous reasons people have questions about their 401(k) accounts. Besides the little education you receive, you are also expected to learn some of the following terms:
- Age-based funds
All of this can be confusing and scary; this is the reason 20% of people don’t participate their company-sponsored plans and over 40% don’t take full advantage of the company match.
The ridiculous thing is your 401(k) plan is one of the most important weapons in your retirement arsenal and rarely do you receive proper assistance. It can help you build wealth, provide retirement income, and leave a legacy.
After working with hundreds of people and reviewing various 401(k) plans, I know the mistakes most people make.
I’ve broken down the most common mistakes that can ruin your retirement plan. If you avoid these four mistakes, your 401(k) plan will be one of your greatest financial weapons.
401(k) Mistakes to Avoid
1. Not Taking Advantage of the Company Match
Your company has probably told you they match your 401(k) contributions. Then give you a paper that says something like the following:
We match dollar for dollar up to three percent; then we’ll match fifty cents on the dollar up to six percent.
If you’re like most people, you probably have no idea what this means.
Let’s break it down:
We’ll assume you make $50,000.
Your company matches you dollar for dollar up to the first 3% you contribute. In this case, if you contribute 3% of your income ($1,500) then your company will match the same amount ($1,500).
However, if you only contribute 2% ($1,000), then they will only contribute $1,000 as well.
If you contribute 6% of your income ($3,000), then your company will still match the first 3%. They will also give you fifty cents for every dollar you contribute on the next 3% or an additional $750.
When you max out your company’s match, you invest $3,000, and your company gives you an additional $2,250.
There is no other investment where you can earn $2,250 on $3,000…that is a 75% increase!
Every 401(k) doesn’t match generously, some don’t match at all, and some have better matches. If you receive a match, make sure you take full advantage. It’s the number one mistake I see most people make with their 401(k) plans.
2. Investing All Your Money in Money Market Accounts
One of the main reasons you have money invested in a 401(k) plan is to make it grow.
However, time and time again I see people invest the majority of their money in a Money Market account. A money market account is a fancy name for a savings account.
The advantages of a money market account are your money is safe, it’s liquid, and you won’t ever see a negative return. The disadvantages are the money won’t keep pace with inflation, your buying power will erode over time, and you aren’t taking full advantage of markets.
Let’s take a look at three Vanguard funds over the past 15 years and their average returns:
- Money Market (VMMXX) – 1.38%
- Bond Fund (VBMFX) – 4.32%
- Stock Fund (VFIAX) – 6.89%
At first glance, these returns don’t seem to vary much, but when they are compounding for 15 years the difference, as Donald Trump would say, is HUGE. Take a look at the chart below:
As you can see, you are better off keeping the money invested in the stock market over the long-term.
Make sure your money is not invested in a money market account in your 401(k). Diversify amongst stocks, bonds, foreign investments, and more.
3. Loading Up on Company Stock
Another mistake I saw many people make, including myself, was load up on company stock.
If you haven’t read my story on how I blew my retirement savings, read this.
When you are working for an organization, it is easy to have confidence in them. Confidence often leads to people blindly investing 50% to 90% of their money in their company stock.
This is dangerous!
The problem with this much exposure is if your company does go bankrupt, then you lose a significant amount of money. This issue has happened at companies like Refco, National City Bank, Enron, and Worldcom.
Try to keep your investments in company stock limited to 10-20% of your portfolio. Keeping limited exposure to company stock helps you mitigate risk and keep a diversified portfolio.
4. Cashing Out Before Retirement
The most expensive thing you can do with your 401(k) plan is cash out before you reach age 59 1/2.
People usually cash out because they are leaving for another opportunity or were let go from their jobs. When this happens you have three options:
Leave your 401(k) money at your previous employer (typically available if you have more than $5,000 invested)
Roll the money over to an IRA or transfer to another 401(k)
Cashing out is devastating on your retirement.
When you cash out, the government likes to get their share now. You have to pay ordinary income taxes on all the money plus a 10% early withdraw if you are under age 59 1/2.
Let’s take a look at an example.
You decided to take all $50,000 out of your 401(k) plan because you want the money. And you are 42.
10% penalty = $5,000
20% Tax bracket = $10,000
You keep $35,000
This means you lost $15,000, but wait…
There is more…
Not only did you lose $15,000, but you also lost all the compounding interest your could have earned over the next 20 years. If you would have gotten a modest 5% return, then you lost additional $82,000 in lost earnings.
DAMN!!! THAT HURTS!
401(k) plans are complicated, but if you can avoid the four common mistakes, then you will be well on your way to a prosperous retirement.