The sad state of the union is that most Americans are woefully underprepared for retirement. Some 48 million working-age households, or 45 percent of the total, do not own any retirement account assets at all. All told, the nation is running a collective retirement savings deficit of between $6.8 and $14 trillion (depending on targets and measures), and it’s only getting worse. The average person has a personal savings rate of less than 5 percent, well below what’s recommended.
There is some good news, though. Even in the wake of the financial crisis, as wages stagnate and long-term unemployment remains high, Americans appear to be contributing more and more to 401(k) retirement plans. 401(k)s are an employee-sponsored savings vehicle. Contributions are made directly from someone’s paycheck and, depending on the account type, are either taxed immediately or tax deferred. According to the Investment Company Institute, 401(k) plan assets account for approximately 18 percent of the retirement market, or about $3.5 trillion of $19.4 trillion. Most of this money, about 60 percent, is invested in mutual funds.
401(k) plans are increasingly popular, but they’re not foolproof. Here are some common mistakes that people make, which could end up losing them money in the long term.
The most fundamental mistake someone could make is to be apathetic about saving for retirement and not make the effort or sacrifices needed to put money away. Unfortunately, financial discipline is tedious bordering on torturous for most people. Many Americans already live paycheck to paycheck and can’t afford to do anything besides take care of present needs. Especially for those who have experienced a financial shock or prolonged financial hardship, the idea of putting money into a savings vehicle is laughable when they are faced with incoming or overdue bills. This situation breeds financial apathy: people tend to stop trying to save if they they think it’s impossible to start.
401(k)s try to slip past this apathy by offering incentives such as pre-tax contributions and tax-deferred growth, which can provide enormous value. In many cases, employers will match up to 50 cents on the dollar for up to 6 percent of your salary that you contribute to the plan. If the implication here isn’t obvious, this is about as free as money gets, and it’s a surefire way to ensure that that present you is looking after future you. If you neglect to feed your 401(k), then you will miss out on both any matched contributions and the tax-deferred growth, both of which are enormous value-adds over other savings vehicles.
2. Neglecting fees
The go-shop process is a hallowed part of any serious purchase agreement. The go-shop period helps ensure that a company’s board of directors stays true to its fiduciary duty, ensuring that shareholders get the best possible deal in the transaction.
The metaphor isn’t perfect, but think of your retirement savings account as a business. You, through the magic of compartmentalization, are both the chairman of the board and the shareholder. You have a duty to look out for your own best interest and ensure that you are not paying any more than you absolutely have to in banking or other fees associated with your retirement nest egg.
The problem is that many people are not familiar with the details of their 401(k), so they could be being charged too much. For some context, here is how high fees can hurt the returns of a savings fund, courtesy of FutureAdvisor.
The U.S. Department of Labor frames the issue this way: “Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.”
3. Early withdrawal
A well-fed 401(k) can turn into a nest egg, and during hard economic times it can be tempting to draw upon the nest egg. While this is sometimes necessary, it should be avoided if at all possible. In most cases, withdrawing funds from a 401(k) before the age of retirement is met with a 10 percent penalty. Only in dire circumstances can you take a penalty-free withdrawal before retirement.
Funds withdrawn early from a 401(k) are also worth more inside of the account than they are outside of the account. Inside the 401(k), your money is invested and enjoying tax-deferred growth. Since growth scales with the size of the investment, withdrawals can dramatically change
To put it another way, early withdrawal is like robbing future you to take care of present you. Make sure what you need the money for is absolutely essential and that there is no other reasonable way to finance the expenditure before you make the withdrawal. And before you do, look through the details of your plan to see if you qualify for any hardship withdrawal benefits.
4. Taking a loan against your 401(k)
Most major employers offer some sort of loan provision for their 401(k) plans. These provisions allow people to borrow against their 401(k) account and then pay themselves back with interest. This makes a 401(k) much more flexible, but it does have its downsides. For one, some plans won’t allow contributions while a loan is outstanding. For another, borrowing money from the account is still robs some compounding interest momentum from future you.
If you’re fortunate enough to have a steady job with a 401(k) program, then it may be easy to let it drift to the back of your mind and forget to check up on it. This opens up two risks. First, if people are not checking the progress of their 401(k)s, then they either don’t have a goal set or they don’t know how they are doing in relation to their goal. If they don’t have a goal, they should set one — if they do, then they should be checking to make sure they are on track. Nobody likes having to play catch-up because they neglected to edit their retirement plan.
Second, there could be an issue with the 401(k) that is going unobserved and therefore unfixed. Anything form a clerical error to a change in the fee schedule for the plan could throw a wrench in your retirement strategy.
Most 401(k) plans will give savers some flexibility in choosing how their money is allocated among various assets. When making this choice, use a strategy that is appropriate for your goals. For example, if you are young and just starting out, it is generally encouraged that you invest heavily in equities, accepting the risk because you have a longer time horizon. As you approach the age of retirement, it’s generally recommended that people shift their money to safer — but slower-growing — assets like bonds.
One of the mantras of investing at any level is “don’t put all your eggs in one basket.” A 401(k) account offers no special protection against sloppy investment decisions such as over-concentration. It’s generally encouraged that people invest in a mix of large-cap stocks, small-cap stocks, foreign stocks, and bonds that shifts over time.
One trap that people sometimes fall into is investing too much in company stock. Although it’s good to root for the home team, over-concentration is still over-concentration.
The market ebbs and flows. The value of your portfolio will change every day and sometimes dramatically, but it’s important not to try to micromanage your portfolio. Don’t dump a fund just because it had one bad quarter — dump a fund because there is a compelling argument for why it is unlikely to perform well in the future. What people need in 401(k) investments are marathoners, not sprinters.
Money invested in a 401(k) is protected by federal law, so unless something goes horribly wrong, no one should lose their 401(k)s if they switch jobs but neglect to roll over their account. Still, failing to do this opens the door to a bunch of risks. 401(k)s can get lost, believe it or not. It can be a herculean task trying to recover information from a company that has gone bankrupt, merged, or been acquired.
The problem is so pervasive, in fact, that the U.S. Department of Labor operates an Abandoned Plan Program to help people find lost accounts. “In some cases, plan abandonment has occurred when the sponsoring employer ceases to exist by virtue of a formal bankruptcy proceeding,” according to the agency. “In other cases, abandonment occurs because the plan sponsor has been jailed, died, or simply fled the country.” Encouraging stuff.
More From Wall St. Cheat Sheet: