Common 401(k) Mistakes
It’s human nature to blunder every now and then, but you’ll pay a higher price for some mistakes than for others. Mismanaging your 401(k), for example, can result in penalties in the short term and cause you to fall short of your savings goals for retirement.
Maximize your savings and tax benefits by avoiding these common 401(k) mistakes.
Mistake 1: Not Taking Advantage of Your Company’s 401(k)
Sixty-eight percent of Americans working in private industry had access to a retirement plan in 2021, but only 51% participated, according to U.S. Bureau of Labor Statistics data. The other 17% missed out on tax deferrals and compounded returns on their investment.
Mistake 2: Not Maxing Out Contributions
The IRS allows you to contribute up to $19,500 in pre-tax dollars to a 401(k) for the tax year 2021 and $20,500 for the tax year 2022 — that’s money you won’t have to pay federal tax on until you retire, at which time your income might fall in a lower tax bracket. What’s more, many employers match some portion of employees’ contributions. You might not be able to contribute the maximum in any given year, but if you don’t at least contribute enough to get your full employer match, you’re literally passing up free money.
Mistake 2: Not Taking Advantage of the Market
Another common error is failing to leverage down markets.
When the markets are down and 401(k) balances take a hit, many people decrease their contributions out of fear they’re throwing money out the window. In the process, they miss an opportunity for dollar-cost averaging — contributing the same amount every month so that you buy more shares when prices are low and fewer shares when prices are high.
Dollar-cost averaging takes the guesswork out of investing and reduces your average cost per share. It also establishes good saving and investing habits that will help secure your finances over time.
Mistake 3: Not Knowing What To Do When You Leave Your Company
Leaving a job can have a significant impact on your 401(k). While any money you’ve contributed is yours, you might not be vested in your employer’s contributions. It could be worth sticking around for a while if you’re close to your vesting date.
Another consideration is what to do with your 401(k) after you leave the company. You can leave the money as is, but you won’t be allowed to make additional contributions — a potential disappointment that could leave you with a larger-than-expected tax bill if you thought you could make a lump-sum contribution at the end of the year. What you can do is roll your previous employer’s 401(k) into your new employer’s plan or an IRA.
Mistake 4: Withdrawing Money From Your 401(k)
An early withdrawal should never be used for discretionary spending, and it should be a last resort for emergency expenses, according to Fidelity. One reason is the appreciation you’ll lose over time. Perhaps more importantly, the IRS will tax your withdrawal as ordinary income even in the case of a hardship withdrawal, plus you’ll pay a 10% early-withdrawal penalty on the full amount you withdraw unless you’re at 59 1/2 or qualify for an exception. As a result, you’ll have to withdraw significantly more money than you need to cover your expense.
A loan against your 401(k) might be a better option. However, you’ll have to repay it within five years to avoid taxes and penalties, and the loan is due in full if you leave your job.
Mistake 5: Not Diversifying
In financially turbulent times, many people seek lower-risk investments to protect their principal, even if it means lower returns. In the long run, however, returns on low-risk investments might not keep pace with inflation, which is currently over 7%. Building a diversified portfolio within your 401(k) is the best way to grow your savings even when inflation is high.
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