Laura Rowley Money & Happiness

What are the top five mistakes of today's 401(k) investors, and how can you avoid them?

Surprising answers are revealed in a new report from the Vanguard Group called "How America Saves 2006," based on data from 1,800 plan sponsors and 2.8 million participants.

The numbers don't lie: Some workers are short-changing themselves by making amateur blunders. On the flip side, the report reveals how savvy investors are making the most of these plans.

Mistake 1: Failure to enroll in an employer's plan

More than one-third of workers who have access to a 401(k) don't bother to enroll. Understandably, many lower-income earners feel they just can't spare a dime after paying the bills: 43 percent of eligible workers earning $30,000 or less were enrolled in their plans in 2005, compared to 83 percent of those earning $75,000 to $99,000.

Meanwhile, just 27 percent of eligible workers age 25 and younger took advantage of their plans in 2005, compared to 68 percent of 35- to 44-year-olds. "People might think they're too young to start saving, and yet money saved early is so much more valuable than money saved later," says Ellen Rinaldi, director of investment counseling and research at Vanguard.

The savvy strategy: Pay yourself first, no matter what your age. Saving 3 percent of a $30,000 salary is $900 a year, $75 a month, or a $2.50 day. More than half of employers allow workers to join their 401(k) plans as soon as they're hired, the study found, and 8 percent automatically enroll workers. Once you get in, sign up to automatically increase your contribution rate by 1 percentage point when you receive your annual raise. You won't miss money that never gets into your pocket.

Mistake 2: Contributing only enough to get the employer match

In 2005, workers forked over an average of 7.31 percent of their salaries to their 401(k)s; the median was 6 percent. "It appears people are contributing enough to get the match," says Rinaldi. More than 90 percent of Vanguard-managed plans offer matching funds.

The most common match is 50 cents on the dollar up to 6 percent. For example, a worker earning $50,000 sets aside 6 percent -- or $3,000 of their own salary -- and the company throws in $1,500. The good news is that most workers recognize the value of a guaranteed 50 percent return on investment.

The bad news? A 9 percent savings rate (the contribution plus the match) may not be adequate for a retirement that lasts 30 to 40 years. "You have to know what your objective is in retirement," says Rinaldi. "Without a specific objective, you could be saving and be surprised later on."

The savvy strategy: Contribute the maximum percentage of salary allowed, something 11 percent of Vanguard 401(k) participants do.

Mistake 3: Keeping too much of your 401(k) in company stock

Some 43 percent of workers were offered their employer's stock as an investment option. Of that group, one-third had stock exceeding 20 percent of their portfolios.

The risk here is well illustrated by the documentary film Enron: The Smartest the Smartest Guys in the Room. (I rented it the weekend after former Enron chief executive Jeffrey Skilling was sentenced to more than 24 years in prison. Two thumbs up.) A 30-year veteran of an electric utility acquired by Enron had his entire portfolio in Enron stock. At the height, his 401(k) was valued at nearly $400,000. He ultimately sold his shares for $1,200.

The savvy strategy: Hold no more than 5 to 10 percent of a retirement portfolio in company stock.

Mistake 4: Taking a loan from your 401(k)

Roughly one in five workers has a loan outstanding from a 401k, borrowing an average of $8,000. But as Rinaldi says, "Taking a loan is a crazy thing to do."

Here's why: Uncle Sam collects twice on the money you borrow, because you pay back the loan with after-tax dollars. When you withdraw the money at retirement, you'll owe taxes on it again. Moreover, if you lose your job, you have to pay back the loan immediately. If you can't, the Internal Revenue Service will consider the loan a withdrawal, and you'll owe income tax on it, along with a 10 percent penalty if you're under age 59-1/2.

Then there's the lost opportunity cost: The money you borrow doesn't earn the tax-free interest it otherwise would. Consider a 25-year-old worker who takes a $10,000 loan from his 401(k). He loses his job and can't pay it back. At age 65, the $10,000 amount would have been worth $242,743, at an 8 percent annual rate of return. Meanwhile, he has to pay several thousand dollars in taxes and penalties.

The savvy strategy: If you think you may need to borrow from your 401(k) for say, a home down payment, put enough into your 401(k) to get any match and open a Roth IRA. The Roth allows you to withdraw your contributions (but not gains) anytime, for any reason, without taxes or penalties. (You must earn $110,000 or less as a single person or $160,000 or less as a married couple filing jointly to open a Roth, although those restrictions will be eliminated in 2010.)

Mistake 5: Failure to properly allocate savings

Some 13 percent of Vanguard plan participants had their entire 401(k) in short-term reserves, or cash -- a far too conservative choice for money that has years to grow. On the other extreme, 19 percent had all of their money invested in stocks -- which may be overly risky. "It's important to make sure you are appropriately allocated for the swings in the market," says Rinaldi.

Unfortunately, some workers don't have a clue what they're buying, or how to keep their portfolios on course.

For instance, one in five participants owned more than one life-cycle fund -- a major mistake. These vehicles are meant to offer one-stop shopping -- a single fund for an entire portfolio. They allocate money in a mix of stocks and bonds, investing more conservatively as you near retirement.

Meanwhile, financial advisors recommend that anyone who is not in a life-cycle fund rebalance his or her portfolio once a year, to ensure it still reflects the original allocation.

Let's say you decide to invest 60 percent of your money in Fund A; 25 percent in Fund B; and 15 percent in Fund C. At the year's end, Fund A has soared in value, and now makes up 70 percent of your portfolio, while Fund B declined to 15 percent. To rebalance, you would sell some of Fund A, and buy more of Fund B.

But many investors don't bother: Over a two-year period, 80 percent of 401(k) investors made no trades at all, Vanguard found.

The savvy strategy: Choose the right allocation strategy, using the online tools provided by Vanguard and other such firms, or by visiting a fee-only financial planner. Rebalance once a year to stay on track. Too complicated? Go with a life-cycle or target-strategy fund, and let the fund managers do the work.