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5 401(k) Gotchas to Avoid

Emily Brandon
5 401(k) Gotchas to Avoid

Between employer contributions and the ability to defer income tax on your own contributions, 401(k) plans often help you come out ahead in retirement saving. However, high fees, expensive investments, poor plan design and a lack of company contributions can sometimes diminish these benefits. Here are five 401(k) pitfalls to watch out for:

[See: 10 401(k) Facts Everyone Should Know.]

Staying at a low savings rate. Automatically enrolling workers in 401(k) accounts typically gets more people to save in the plan, increasing the participation rate from 65 percent in plans with voluntary enrollment to 82 percent in plans with automatic enrollment. However, participants who are automatically enrolled in 401(k) plans have an average savings rate of 4.9 percent of pay, which is about 35 percent less than the 7.5 percent of pay people who voluntarily sign up for the plan save, according to a Vanguard analysis of 1,900 plans with 3.5 million participants. Workers often save less when they are automatically enrolled because the default savings rate is usually low -- typically 3 percent of pay -- and not all employers automatically escalate the savings rate each year. People who are defaulted into the plan at a 3 percent savings rate may additionally miss part of a 401(k) matching contribution because most employers (77 percent) require employees to save between 4 percent and 6 percent of their salary to get the entire match. It's better to select your own savings rate based on your ability to save and your retirement needs, taking into account your employer's 401(k) match formula. Also, consider increasing your savings rate as you get raises and bonuses. "Any time you get a raise, pay yourself half the raise," says Steven Bové, a certified financial planner and president of Lebrigh Life Planners in Oldsmar, Florida. "If it's a 4 percent raise, then put 2 percent more a month in your 401(k)."

Sticking with the default investment. When you are automatically enrolled in a 401(k) plan, your money will be allocated to a default investment of your employer's choosing, typically a target-date mutual fund. While default investments are chosen to suit the investment needs of the majority of the company's workforce, the level of risk and the fees associated with the investment may not suit your personal preferences and risk tolerance, especially if you have other assets outside the 401(k) plan. Make sure you examine your company's default investment and compare it with the other fund options in the plan before contributing money from every paycheck. "It's important to pay attention to what you are investing in and the fee," says Teri Alexander, a certified financial planner and president of Alexander Financial Planning in Columbus, Ohio. "The best way to go in is to go into a no-load mutual fund so there is no upfront cost and no back-end charge, and also be mindful of the internal expenses of the mutual fund."

[See: 10 Trendy 401(k) Plan Perks.]

Leaving before you're vested. When you leave a job, you don't get to keep the 401(k) match your employer provides until you are vested in the 401(k) plan. Less than half (45 percent) of 401(k) plans immediately vest all employer contributions. Some companies permit workers to keep a percentage of the employer contributions based on their years of service, but they typically don't get to keep all of it until they have been with the company for five (19 percent) or six (14 percent) years. Other firms (16 percent) don't allow employees to keep any of the 401(k) match until they have stayed on the job between one and three years. While you may not want to pass up a better job opportunity because you aren't vested in your retirement account, if you are close to vesting, sticking around a few extra weeks or months could add thousands of dollars to your retirement savings.

Cashing out when you change jobs. It can be tempting to spend the money in your 401(k) account when you change jobs, but the cost of an early withdrawal from a 401(k) plan is seldom worth it. A worker under age 55 who is in the 25 percent tax bracket and withdraws $5,000 from his 401(k) plan after he leaves his job will owe $1,500 in income tax and early withdrawal penalties. The taxes and penalties can be avoided by leaving the money in the 401(k) plan or rolling it over to an individual retirement account or a new employer's 401(k) plan. "If your new job has a reasonably large 401(k) plan that has a reasonably inexpensive mutual fund lineup, you can keep things simple and move it into the 401(k)," says Therese Govern, a certified financial planner for Therese Govern Financial Advisors in Seattle. "If you are moving to a job where the 401(k) plan stinks, your better option is to roll to an IRA."

[See: What Everyone Should Know About IRAs.]

Not saving during waiting periods. Many employers don't allow workers to join the 401(k) plan as soon as they start a new job. Only about half (55 percent) of 401(k) plans offer immediate eligibility for the retirement plan, while others don't let employees start contributing to a 401(k) plan until they have between two and six months (22 percent) or even a year (17 percent) of job tenure, Vanguard found. Most employers make workers wait even longer to become eligible for a 401(k) match. Less than half (44 percent) of employers immediately provide a 401(k) match to new employees, and 28 percent require a year with the company before contributing to the retirement account. While it's more convenient if you can start contributions to a 401(k) with your first paycheck at a new job, it's important to take note of when the waiting period ends and sign up then. Also consider contributing the amount you would have saved in the 401(k) to an IRA so you can get a tax break and continue to build your nest egg.



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