The Top Mistakes People Make with Their 401(k)s and How to Avoid Them
As a Chartered Financial Analyst (CFA) with over 20 years of experience in finance, including managing Investment Risk and Investment Product Teams, I’ve seen countless individuals make costly mistakes with their 401(k) plans.
A 401(k) is a powerful tool for building retirement wealth, but many people fail to optimize its potential.
Below, I’ll outline some of the most common mistakes and provide alternative strategies to help you maximize your 401(k) and secure a more comfortable retirement.
Table of Contents
1. Not Taking Advantage of the Company Match
One of the most common and significant mistakes is not contributing enough to your 401(k) to get the full company match. Many companies offer to match a certain percentage of your contributions, effectively giving you free money. Failing to contribute enough to get this match is akin to leaving money on the table.
Alternative Strategy
Always contribute at least enough to your 401(k) to receive the full company match. If your employer matches 50% of the first 6% of your salary, ensure you’re contributing at least 6%.
This match is an immediate 50% return on your investment, which is hard to beat.
2. Settling for the Match but Not Maxing Out Contributions
While getting the company match is essential, stopping there is another common error. Many people contribute only enough to get the match and miss out on the substantial tax advantages of maxing out their 401(k).
I am a big advocate of maxing out your 401k. I have always looked at it as funding my retirement is not my money. It is future me’s money. I never steal, so its imperative that I save for future me. It’s easy to not max out a 401k and spend the money elsewhere. But don’t do it.
Assume you don’t have the money and find a way to afford your life without the money you are using to max out your 401k. It’s hard. I know it’s hard. I’ve done it. My money is where my mouth is.
Alternative Strategy
Aim to contribute the maximum allowable amount to your 401(k) each year. For 2024, the contribution limit is $23,000 for those under 50, with an additional catch-up contribution of $7,500 for those 50 and older. Maxing out your 401(k) can significantly boost your retirement savings while reducing your taxable income.
3. Misusing Target-Date Funds
Target-date funds are designed to be a one-stop solution, adjusting their asset allocation as you approach retirement. Many people make the mistake of using a target-date fund as part of a larger, more complex portfolio, which can lead to an inappropriate risk level for your overall investment strategy.
Alternative Strategy
If you choose a target-date fund, avoid mixing it with other investments unless you have a clear strategy for doing so. A target-date fund is meant to be a comprehensive solution. If you add other funds, you might unintentionally increase your risk or misalign your investment horizon.
If you prefer to take a more hands-on approach, consider building a diversified portfolio that aligns with your risk tolerance and retirement timeline.
4. Equal Weighting the Portfolio
Some investors make the mistake of equally weighting their 401(k) portfolio across different funds without considering the underlying asset allocation. This can lead to an unintentional over-concentration in certain asset classes, increasing your portfolio’s risk.
Alternative Strategy
Instead of equal weighting, focus on creating a diversified portfolio that reflects your risk tolerance and investment horizon. This means carefully selecting funds across various asset classes (stocks, bonds, real estate, etc.) and adjusting the allocation based on your financial goals.
Regularly review and rebalance your portfolio to maintain your desired asset allocation.
5. Never Rebalancing the Portfolio
Over time, different investments in your 401(k) will grow at different rates, leading to an unbalanced portfolio that may no longer reflect your original investment strategy. This can expose you to more risk than you intended.
Alternative Strategy
Set a regular schedule for rebalancing your 401(k) portfolio, such as annually or semi-annually. Rebalancing involves adjusting your investments to return to your target asset allocation, ensuring your portfolio remains aligned with your risk tolerance and investment goals.
Some 401(k) plans offer automatic rebalancing, which can be a convenient option to maintain your strategy over time.
6. Taking Out a Loan Against Your 401(k)
Borrowing from your 401(k) might seem like an easy way to access funds in an emergency, but it can be a costly mistake. Loans from a 401(k) typically need to be repaid with interest, and if you leave your job, you may be required to repay the loan in full within a short time frame.
If you can’t repay, the loan is treated as a distribution, leading to taxes and penalties.
Alternative Strategy
Avoid taking loans from your 401(k) unless it’s an absolute last resort. Instead, build an emergency fund in a separate savings account to cover unexpected expenses.
If you must borrow from your 401(k), have a solid repayment plan and explore other options, such as a home equity loan, before tapping into your retirement savings.
7. Ignoring High Fees
Many 401(k) plans offer a variety of investment options, but not all are created equal. Some funds have higher expense ratios, which can eat into your returns over time. Investors often overlook these fees, but they can have a significant impact on your retirement savings.
Alternative Strategy
Pay close attention to the expense ratios of the funds in your 401(k). Opt for low-cost index funds or ETFs where possible, as these typically have lower fees than actively managed funds. Reducing fees by even a small percentage can lead to thousands more in your retirement account over time.
8. Failing to Consider Tax Diversification
While 401(k) contributions are tax-deferred, many investors forget to consider tax diversification in their retirement planning. Relying solely on a 401(k) can lead to significant tax liabilities in retirement when distributions are taxed as ordinary income.
Alternative Strategy
Consider diversifying your tax exposure by contributing to a Roth 401(k) if your plan offers it. Unlike traditional 401(k) contributions, Roth contributions are made with after-tax dollars, but qualified withdrawals in retirement are tax-free. By having both traditional and Roth accounts, you can better manage your tax burden in retirement.
9. Underestimating the Importance of Beneficiary Designations
Many people forget to review or update the beneficiary designations on their 401(k) accounts. Failing to update beneficiaries after major life events, such as marriage, divorce, or the birth of a child, can lead to unintended consequences.
Alternative Strategy
Regularly review and update the beneficiary designations on your 401(k) account, especially after significant life events. Ensure that your retirement savings will go to the intended recipients by keeping this information current.
10. Cashing Out When Changing Jobs
When changing jobs, some people opt to cash out their 401(k) instead of rolling it over into a new retirement account. This decision can result in taxes, penalties, and a significant reduction in retirement savings.
Alternative Strategy
When leaving a job, consider rolling your 401(k) into your new employer’s plan or an IRA. This allows your investments to continue growing tax-deferred. Rolling over your 401(k) is usually a straightforward process and helps keep your retirement savings intact.
11. Not Adjusting Contributions with Income Increases
Many people set their 401(k) contributions when they first start working and then never adjust them, even as their income increases. This can lead to missed opportunities for growing your retirement savings.
Alternative Strategy
Increase your 401(k) contributions whenever you receive a raise or bonus. By allocating a portion of your increased income to your 401(k), you can gradually boost your savings without significantly impacting your take-home pay. Setting up automatic increases, if your plan allows, can make this process easier.
Conclusion
Your 401(k) is one of the most important tools for securing a comfortable retirement, but it requires careful management to avoid common pitfalls.
By understanding and addressing these mistakes you can maximize your 401(k)’s potential. Implementing the alternative strategies outlined here will help ensure that your retirement savings grow efficiently and effectively over time.
If you’re unsure about any aspect of your 401(k) or need personalized advice, consider consulting a financial advisor who can provide tailored guidance based on your unique situation.
Remember, the decisions you make today will significantly impact your financial security in retirement.
