Avoiding these 401K mistakes will put you on the fast-track to the retirement of your dreams
401K plans are the best thing to happen to investing since…well, ever! As an equity analyst and someone that has worked with private wealth managers, I can tell you without a doubt that enrolling in your company-sponsored 401K plan is the best investment you can make.
Company match contributions are like free money and the tax savings on a 401K mean higher returns than any stock-picker could wish.
But that doesn’t mean investors can’t muck it up.
To be fair, companies and plan administrators are horrible at explaining plans. Sometimes it’s just an oversight while other times it’s to purposely steer you into expensive funds.
Regardless of who is at fault for all the mistakes made in this otherwise excellent opportunity, this list of the worst 401K investing mistakes will help you keep your retirement on track. I’ll describe each, why it happens and then offer a few ideas on how to avoid making the mistake yourself.
Many of these are going to be repeated topics we’ve already covered in the book but they’re extremely important so I wanted to make sure to get the point across. In fact, this is possibly the most important chapter in the book.
Avoiding these 11 mistakes will make sure you get the most out of your 401K!
I’ve ordered the list with the worst mistakes first but that doesn’t mean the latter mistakes are any less dangerous. Make sure you keep the list handy to recheck every five to ten years to make sure you’re not committing any of these mistakes because almost everyone stumbles into them eventually.
1) Not maxing out your 401K employer contribution (or not participating at all)
Of course this had to be the first and biggest mistake. You can’t make any other mistakes in your 401K if you’re not participating.
According to the Department of Labor Statistics, about half (55%) of the working population has access to a 401K program but only two-of-three eligible employees participate in their plan. I’ve heard a lot of excuses for why someone isn’t investing in a 401K plan from not having the money to not wanting to lock-up the money until retirement.
There’s no good reason for not participating in a 401K plan…none.
If you have a company-sponsored 401K and if your company offers any kind of a match contribution, the first thing you need to do when you get to work tomorrow is ask for the enrollment forms to your plan!
Beyond participating in your plan, you should be maxing out the employer contribution. Scratch that, you MUST be maxing out the employer contribution.
Even if your 401K plan has a restrictive vesting schedule or your employer doesn’t match dollar-for-dollar, this is free money and the easiest investment return you’ll ever earn. Getting that company match of 50% is an instant return more than five times the average annual market return…why would you ever not take advantage of that?
I know I’ve harped on this idea constantly but it always amazes me to hear that someone isn’t maxing out their employer 401K contribution.
Maxing out the contribution usually means only sacrificing about 6% of your salary, that’s the average cap on employer matching. If you make $42,000 a year, that means investing just $210 a month into your 401K plan to get that full match. Getting a 50% match and earning a modest 8% annually means those contributions grow to over $428,000 in 30 years.
That’s more than twice the average 401K balance for Americans at retirement age.
Even better, your investment really only cost you about $165 a month. That’s the amount you would have gotten after taxes if you’re in the 22% tax bracket.
If this chart showing the power of even this small monthly 401K investment doesn’t convince you to take advantage of your plan…good luck with your Ramen noodles and oatmeal in retirement!
2) Taking a 401K loan or withdrawal
I know a lot of people will disagree with me but I say taking a loan or withdrawal on your 401K account is about as bad as never having started at all.
Not only will you pay the taxes you would have paid on the contribution but you’ll usually be out an extra 10% penalty in a withdrawal. What’s worse is that your income tax rate might be higher now than when you invested the money so you’re actually paying more taxes than you would have originally.
Even if by some miracle you avoid the 10% penalty for early withdrawal, you’ll have set yourself back years on your retirement planning and may not be able to reach your goals.
As for a loan, many will argue that it’s a cheap source of money considering the prime rate on a 401K loan is always going to be well under the rate you’re paying on credit cards. Those same people would argue that the interest you pay goes back into your account so your portfolio is still growing.
The problem with a 401K loan is that you repay the money with after-tax dollars. Then when you withdraw the money again in retirement, you pay taxes AGAIN! Paying yourself that 5% interest repaying your loan is chicken feed compared to paying an extra 15% or more on the tax bite.
But doesn’t it still make sense to take out a loan if you can pay off high-rate credit cards?
Ok, but ask yourself why you have that credit card debt. What’s keeping you from running up the cards again? I hope it’s not sheer determination alone.
Your 401K money is sacred. Even if it seems to make all the financial sense in the world, don’t withdraw or loan on your 401K plan. Unless it’s literally a matter of life or death…just don’t do it!
3) Cashing out instead of rolling it over when you leave employer
More than one-in-three people that leave their employer-sponsored plan will cash out their 401K and take the money. The biggest reason I hear is that, “It’s only a few thousand and won’t matter much anyway.”
Really? So $20,000 is no big deal?
That’s how much just $3,000 grows to over 25 years at an 8% annual rate. You’d get about $2,200 after taxes and penalties if you cashed out the money or could have nearly ten-times that amount for retirement.
By the way, if you said $20K is no big deal…call me! I’ve got a bridge to sell you.
You can leave the money with the current plan administrator, though I don’t usually recommend it. You won’t be able to make new contributions and your old employer certainly isn’t going to be putting in any money.
You can roll your 401K investments into another 401K plan at your new employer though the benefits are limited. You’ll avoid paying the 10% penalty and taxes. Your retirement investments will keep growing and all your money will be in one place.
On the other hand, you won’t get any contributions from your new employer for money brought from the old plan and 401K plans are notorious for high fees. You’ll pay an annual expense fee on the money you bring over from your old plan and may even pay other fees for the transfer.
It’s easy enough to roll your old 401K money into an IRA. This move gives you the most flexibility and saves the most money. With a 401K-to-IRA rollover, you get access to low-cost exchange traded funds that charge a fraction of the fees you’ll pay in a 401K account.
Your investing platform or broker will help transfer the money from the old 401K plan administrator. The check for your funds should be made out to your IRA account, not to you personally. This will avoid owing the 10% withdrawal penalty come tax-time.
4) Not comparing expense ratios on 401K investment options
Participating in your 401K plan and not taking the money out may seem like no-brainers. Comparing the expense ratios on available funds might not be as obvious but will cost you tens of thousands.
Paying a 1.25% annual expense, the average expense ratio on mutual funds, will cost you $48,700 over 30 years on a monthly contribution of $210 plus the employer contribution. That’s almost $50,000 and doesn’t even include the returns you would have made on that money.
Select a low-cost exchange traded fund (ETF) instead, which average a 0.44% annual expense ratio, and you save more than $31,500 over the same period.
You high-rollers out there might not be too impressed with $30K but look at the difference when you factor in compounded interest. The difference between a portfolio invested in mutual funds at a 1.5% annual fee and a portfolio of ETFs at a 0.25% fee is almost $74,000 for retirement!
None of this includes other fees you might have to pay to invest in your 401K, more on that in the next mistake.
Comparing expense ratios for your 401K investment options needs to be done across plan providers and funds within each plan. It doesn’t do any good to enroll with the plan provider with the least expensive AVERAGE fund cost if all the funds you want charge higher fees.
- Determine which types of funds you want for your 401K portfolio; i.e. types of stock funds, bond funds and real estate. Most investors will want a couple of stock funds including Large-Cap and International, at least one bond fund and a real estate fund if it’s available.
- Make a list of the expense ratios in these funds for each plan provider before you pick one to enroll in your 401K.
- You also want to look within each plan to see if there are similar funds to the ones you want that might offer lower annual expense charges.
This will help you not only pick the retirement plan provider with the lowest fees for the funds you want but also some ideas on lower-cost funds within the plan.
5) Not asking for a complete and understandable list of 401K fees
Every 401K plan advisor will tell you their fees are clearly listed in the fund prospectus. They know full well that nobody has ever gotten through a full prospectus in the history of man.
In fact, the Food & Drug Administration is considering forcing all 401K plan providers to put a warning label on plan documents, “Do not read while operating heavy machinery. May cause drowsiness.”
Advisors have to be honest about their fees if you ask them directly but they’re betting that most people won’t want to confront them. They know that most investors will just sheepishly nod their head in agreement when asked if they’ve read the documents and understand all fees.
We’ve already seen how just a 1% difference in the annual expense charged on a fund can cost you tens of thousands of dollars. Now imagine that percentage difference is doubled and hundreds of dollars in other fees are piled on top.
This is your money! You shouldn’t have to spend hours reading through a prospectus to understand your 401K plan and you shouldn’t be made to feel ashamed for asking the plan advisor directly.
Here’s an easy solution to compare the fees across potential 401K providers. Write down the list of possible fees below and have a column for each plan provider. Then ask each to list their relevant fees on each row and sign their name at the bottom.
- Administration Fees
- Investment Management Fees
- Fund Operating Expenses
- Annual Plan Fees
- Wrap Fees
- Trustee Custodial Fees
- Sales Load or Other One-Time Fees
- Services Fees or Commissions
This keeps providers from ‘conveniently’ forgetting to mention a fee or later claiming they told you about it. Any provider that doesn’t want to list their fees clearly in this way is trying to hide the fact they overcharge their customers.
DO NOT NEGLECT THIS ACTION! This one simple step will save you tens of thousands of dollars, minimum! You’ll be able to choose the lowest-cost plan provider and will be on your way to beating your retirement goals.
6) Not investing broadly in stocks, bonds and real estate
The world does not turn on stocks and bonds alone.
I’m not going to get into a long argument on the importance of diversification or why real estate is an amazing asset class. It’s true that bonds provide for good protection during a market crash and that stocks should provide for the upside growth you need over decades, but why not have both?
By investing a portion of your money in a real estate fund, you get added protection from a stock selloff along with a cash flow investment that produces double-digit annual returns.
Every investor should have at least a three-asset portfolio with stocks, bonds and real estate. I would argue for adding another asset with startup investing or peer-to-peer investing but I’d settle for everyone diversifying out to the three assets.
If your 401K plan doesn’t offer real estate funds, and many of them don’t unfortunately, then invest your separate IRA money into a group of real estate investment trusts (REITs).
Even if your plan offers only stocks and bonds funds, you still need to make sure you’re investing broadly to spread your risk. I see two many 401K portfolios invested entirely in a fund of growth stocks and a fund containing only Treasury bonds.
The problem a lot of times is that plans offer too many fund choices. It’s information overload and investors end up just choosing a few funds recommended to them by the advisor, funds that just happen to charge the highest fees.
In the spirit of simplicity, I’m going to list out a few types of funds I think everyone should have in their 401K. Remember, I’m not your advisor and don’t know your specific investment needs so these should only be taken as suggestions against your own research.
- A large-cap U.S. stocks fund for general market returns
- A large-cap international stocks fund for foreign diversification
- A mid- or small-cap U.S. stocks fund for growth
- A U.S. commercial real estate fund
- An investment-grade corporate bond fund
You can certainly add a couple of other funds to this list for your portfolio but these will give you broad exposure to stocks for growth and protection against a market crash.
Understand that fund companies love to create sexy-sounding funds with words like ‘Endeavor’ and ‘Enterprise’ and ‘Omega’. They’ll also use every combination of words like Growth, Value, Low-Volatility and the different capitalization sizes to create a massive list of fund choices.
Always go back to the idea of owning a small number of funds with the lowest expense ratios available.
7) Not rebalancing your 401K investments
A study of 20,000 401K participants by Fidelity found 81% of savers had not rebalanced their investments in more than a year and more than a third had never rebalanced at all.
What’s rebalancing and why is it a problem?
Ask any would-be retiree with most of their money in stocks around 2008 why rebalancing is so important.
Having money in the three asset classes; stocks, bonds and real estate gives you the growth you need to reach your goals along with protection so your money is there when you need it. When you’re younger and have decades to invest, you can have more of your money in stocks because you’ve got plenty of time to see your investments rebound after a crash.
As you get older, your priorities shift to protecting the money you’ve saved so that a crash doesn’t wipe you out just before retirement.
One of the great benefits of 401K plans, the fact that money is taken out of your check automatically, is also one thing that gets a lot of people in trouble. People forget about their 401K investments. Decades pass and the investor is still putting their money in the same allocation of stocks, bonds and real estate.
Besides the problem that you could be putting more money into stocks than you should, your investments in funds tend to grow outside your targets over time. Stocks surge during a bull market so money you have in stock funds is going to grow faster than your bond funds. A portfolio that might start with 70% in stocks and 30% in bonds could end up with 85% in stocks over a decade or two.
That same survey by Fidelity found nearly one-in-three savers age 55 to 59 had 90% or more of their money in stocks.
The amount you have invested in each of these three assets; stocks, bonds and real estate, is going to change as you age and along with your changing priorities.
- Generally, investors younger than 35 will want as much as 70% in stocks, 20% in real estate and 10% in bonds.
- Between 35 to 55 years of age, start shifting some of your money from stocks to bonds and real estate. An example portfolio might look something like 60% in stocks, 25% in real estate funds and 15% in bonds.
- By the time you get five to ten years out of retirement, your priority will shift to protecting your money so it’s there when you need it. An example portfolio might have 50% in stocks, 25% in real estate and 25% in bonds.
These are only examples and your targets for each asset class are going to depend on personal factors including your age, amount saved already, financial goals and your tolerance for investment risk. Shifting your targets for each asset and rebalancing your portfolio every five or ten years will make sure your investments best suit your needs.
You won’t be caught off guard by a stock market crash delaying your retirement and you might even be able to take advantage of cheap stock prices when it happens.
8) Trading in and out of stocks
This 401K mistake would be higher but most people don’t have access to a Broker Window in their plan so it’s not an issue.
401K plans that offer a Broker Window, the ability to buy and sell individual stocks rather than just plan funds, might seem like a good idea but it usually comes at a big cost.
First is that the fees or commissions to buy or sell individual shares are almost always way more expensive than you’ll find with an online investment platform. Transaction fees are generally $10 or more and these types of plans usually charge higher annual maintenance fees as well.
If you get one thing from this book, it should be that fees are a killer!
The second problem with a broker window is that it sets you up to make one of the worst mistakes in investing, thinking you can beat the market buying and selling stocks. Besides the huge cost in fees, you’ll end up panic-selling at the worst possible moment and getting caught up in investor enthusiasm buying at market peaks.
Solution, don’t use the broker window in your 401K plan. Stick with funds. If you want to buy individual stocks, do so with the money in your IRA account so you can invest through a low-cost online investing platform like Ally Invest.
9) Too much in company stock
This is a tricky one because employees can feel a lot of pressure to invest in company stock. Some companies might offer discounts to market price or contribution matching on company stock in your 401K.
There’s one huge problem with having a lot of your money in company stock, whether it’s in your 401K plan or otherwise. It’s not the fact that the company could go bankrupt and crush your nest egg. That’s bad enough as thousands of Enron employees found out in 2001.
It’s the fact that this could be happening at the worst possible moment, when you lose your job.
The company doesn’t even have to go under for this nightmare scenario to happen. A few bad quarters financially could cause the share price to plummet. When this happens, the first thing management thinks of to protect their hefty year-end bonuses…mass layoffs.
It’s ok to invest in the company stock but you should hold it to the same rule as any other stock in your portfolio. Never have more than 5% to 10% of your total wealth in a single company.
Losing that entire 10% of your wealth if a company bankrupts is still a punch in the gut but it’s not going to break you.
10) Choosing 401K funds based on past performance
Ever wonder why the past returns of a fund are displayed next to each option?
Any financial advisor will admit that past performance is no indication of future returns. Returns produced by a fund or even the broader market in the past have nothing to do with what will happen in the future.
So why are those annualized fund returns shown so prominently?
Plan advisors love to sell investors on funds that have produced double-digit returns, even if it’s only happened over the last few years. Investors buy into the funds with dollar signs in their eyes, never looking at those higher-than-average fees.
We’re actually coming up on a very dangerous time for investors making this very mistake. Funds generally show investment returns on a one-, three-, five- and ten-year basis. Normally that ten-year period includes a bear market so the huge returns of a bull market are smoothed out a little.
If the current bull market extends past March 2009, all the disclosed returns in those time periods will only include the good times. Even horrible fund managers will be able to show double-digit annual returns on their funds, selling investors into expensive fees on the promise that these returns will keep building.
In fairness, plan providers are required to disclose annualized returns but they have all kinds of tricks for making their funds look better. They can highlight a given period of returns or just drop under-performing funds altogether.
The only reason past returns on a fund matter is to compare it against the benchmark index. That’s the group of stocks or bonds most similar to the fund objective. If the fund’s past returns have under-performed the comparison by a wide margin, the manager isn’t doing their job right.
11) Going the easy route with a Target Date Fund
Target Date funds hold a mix of stocks and bonds in a certain proportion suitable for someone with a certain retirement age.
For example, a 2040 Target Date fund would have a very high percentage, probably 85% or higher, in stocks because investors have more than 20 years left to retirement. Conversely, a 2030 Target Date fund would have much less in stocks because of the shorter time before investors need to start counting on their money.
Target Date funds adjust each year to hold a different amount in stocks and bonds, appropriately shifting from risky to safer as investors get closer to their retirement age.
Sounds awesome, right? One fund that holds all your stock and bond investments. You don’t have to worry about asset targets or rebalancing.
The problem is that these funds usually come with much higher expenses and are generally invested more conservatively than necessary. Target Date funds can charge expense ratios twice what you’d pay in another fund. They also rarely offer any exposure to real estate.
We’ve already seen how a simple portfolio of five funds can give you access to different types of stocks, real estate and bonds. Rebalancing doesn’t have to be complicated and is only necessary every five or ten years.
Don’t pay someone tens of thousands of dollars from your 401K account for something you can easily do yourself.
That said, I do understand the attraction of Target Date funds which is why this is the last mistake on the list. It’s not a deal-breaker if you choose to invest in one of these funds but I’d like to see you save that money and enjoy the higher portfolio value in retirement.
That’s a thorough list of 401K mistakes and if you can avoid making these eleven missteps, I feel confident you’ll be on your way to a fully-funded retirement. Don’t just read through the list. Make sure you keep it handy and set a reminder to check it every decade or so. It’s easy to fall back into some of these mistakes and they can severely crimp your 401K portfolio.