401(K) plan is one of the best retirement plans to grow your retirement savings. The plan gives you direct tax benefits, comes with higher contribution limits, and you may get an employer match to the plan. All these benefits allow you to grow your retirement account much faster on a tax-deferred basis. While you can enjoy 401(k) benefits, there are 401(K) mistakes you should avoid at all times to get the most out of the plan.
Without understanding 401(k) mistakes to avoid or how the plan works, you might end up losing a lot of money in fees or leaving money on the table.
Let’s take a look at a common 401(k) mistake a lot of people make when saving for retirement: Withdrawing your money before you retire. Tapping into your 401(k) funds before turning 59½ leads to paying a 10% penalty and income tax on your withdrawals. These 2 charges can easily eat up over 40% of your withdrawal leading to only taking home half of your money. That is how a person makes a $75,000 early withdrawal from a 401(K) plan and ends up taking home $40,000. To some people, this is a rip-off. But, in reality, it is a 401(k) mistake that could have been avoided.
You don’t have to make the same 401(k) mistakes. This article will walk you through 13 common 401(k) mistakes you should avoid when saving for retirement to boost your savings and maximize your return on investment.
Without further ado, let’s get started.
1. Contributing too little to your 401(k) plan
When it comes to saving for retirement, the more you save the better. This is because saving more money in the account reduces your taxable income and increases your savings. The more money you have in the account, the more investments you can buy, and the higher the return on investment(ROI).
One of the biggest 401(K) mistakes a lot of people make when saving for retirement is to contribute too little. If you have been saving a few dollars in your plan and have not seen significant growth, it is time to contribute more if you can afford to do so. Contributing more also allows you to take advantage of your full employer match.
2. Putting all your retirement savings in a 401(K)
Although your 401(K) plan will let you stash away a big chunk of your before-tax wages, it might not be a good idea to only contribute to a 401(k) plan. Unless you are maxing out all your retirement accounts, you should max out your 401(k) only after you have contributed to an IRA.
The money in your 401(K) will be locked in an account you do not have control over. The account will be managed by an investment company which comes with 401(K) fees. On top of these fees, you are limited to investment varieties inside the plan. Your company can also change the management company and move your account, and you will not have a say in these activities.
For this reason, contributing only to a 401(k) plan is a mistake that you should avoid at all times.
To avoid this common 401(k) mistake, consider other retirement-saving accounts as well. Invest a small percentage in your 401(k) and put some in an IRA. For example, if you open an individual retirement account (IRA), you will enjoy paying less fees and having a wide variety of investments. Having access to different asset classes allows you to buy investments that have higher returns.
Read more: How much should you contribute to your 401(K) plan in 2024?
3. Not contributing at least up to the employer match
If you have a 401(K) and your employer contributes to your plan, you should contribute at least up to your employer match percentage. This is because the amount your employer puts in your account is your free money. Who does not like free money? Well, some people don’t.
One of the most common 401(K) mistakes a lot of people make is to contribute less than what their employers are willing to match them. For example, if the employer matches your contributions 100% up to 6%, you will not get the full 6% if you don’t contribute at least this percentage of your income. For example, if you contribute only 2% your employer will match that 2%. That means you are leaving that 4% of your gross income on the table.
If you want to maximize your retirement savings, contribute at least up to your employer’s match. This retirement saving strategy will allow you to take advantage of every free dollar in your plan.
Related: 6 benefits of 401(k) plan: Why is 401(K) good?
4. Not starting early
The best and easiest way to save for retirement is to start early. The longer you stay in the market, the easier you can reap all the benefits. When you are young, you can even contribute a small percentage and still meet your retirement saving goals. But, if you are 50 or 55 and have not started saving yet, you will need to aggressively save more money which can easily put you under financial stress. you also run the risk of not meeting your retirement saving goals when you push your retirement savings later. For these reasons, waiting until you are close to retirement to save money is one of the biggest 401(K) mistakes you will ever make.
When you are close to retirement, it is already too late to take full advantage of 401(k) tax benefits and account growth through compounding. You can still make meaningful contributions and attain high growth. However, it will be much harder for you compared to someone who started at an early age.
Compound interest is everything when it comes to investing. The interest you earn on your money gets reinvested over and over. That is you end up earning interest on interest. Eventually, your account starts growing exponentially.
The only way to take advantage of compound interest when you are older is by increasing your contributions. This could be harder depending on your financial conditions.
5. Not knowing the 401(k) contribution limits
The contribution limits for different retirement accounts get adjusted every year. When saving for retirement, it is critical to keep up with these changes and increase or reduce your contributions accordingly.
For example, the contribution limit to a 401(k) plan in 2023 was $22,500 or $30,000 if you are 50 or older. But, in 2024, the maximum contributions limits to a 401(K) are $23,000 or $30,500 if you are 50 or older.
Why would you worry about these 401(k) changes?
One big benefit of the 401(K) plan is that it automatically reduces your taxable income for the year you contributed. If you have a higher income now and want to reduce your tax liability; it would make sense to max out your 401(K). So, if you are still using limits from 2023 or 2022; you will be contributing less than what you are allowed to contribute. Those few thousand dollars you will not be contributing can easily put you in a lower tax bracket.
Read more: What are the 401(K) contribution limits in 2024?
6. Not checking 401(k) fees
A big drawback of the 401(K) plan is that it comes with higher fees compared to IRA fees. This is because your account is professionally managed, and therefore, you must pay fees related to all account activities.
401(K) fees are grouped into 3 categories:
- Administrative fees. These include recordkeeping fees, compliance fees, reporting fees, etc.
- Investment fees. Actively managed accounts and investments come with higher fees. These fees are known as the expense ratio and it is expressed as a percentage of your total account.
- Individual service fees. These 401(k) fees are those you pay on personal services like moving your money, getting 401(K) loans, etc.
401(k) fees can range from 0.22% to 5% of your total account value. If you are not careful, these fees can eat up most of your returns making it one of the biggest 401(k) mistakes you can ever make. Even if the percentage you pay is small, it can cost you hundreds of thousands of dollars throughout your lifetime.
A simple way to lower your 401(K) fees is to pick investments with low fees within your plan. For example, actively managed mutual funds come with higher fees. So, you can lower your 401(K) fees by not picking these funds.
If you want to learn more about 401(k) fees and how you can lower them, read the following article.
Related: What are the 401(K) fees and how to lower them?
7. 401(K) mistakes: Making early withdrawals
One of the biggest 401(K) mistakes a lot of people make is to withdraw money before they retire.
The money in your retirement account is there for retirement purposes only. That is why the IRS lets you defer taxes until retirement.
It is like a contract you have with the IRS which allows you to pay less tax now and grow your account without paying tax until you have retired. In return, you agreed to not touch the money. Taking money out early is a breach of this contract.
One of the biggest 401(k) mistakes many people make is to withdraw money before they retire which leads to paying an early withdrawal penalty and income tax.
According to the IRS, you must be at least 59½ to withdraw money from your 401(K) without a penalty. Early withdrawal will result in a 10% penalty and tax obligations on the money you withdraw. There are times when you can avoid this penalty. Check the IRS exceptions to see if you qualify for that 10% penalty waiver.
To avoid this 401(K) mistake, make manageable contributions and do not take your money out before you reach 59½.
You might also like: Can you lose your 401(k) plan?
8. Forgetting required minimum distributions(RMDs)
One of the biggest 401(K) mistakes a lot of people make is forgetting to take required minimum distributions (RMDs). 401(K) is one of many retirement plans that come with mandatory withdrawals for people who are 73 or older.
Without taking the money out in a given time, you may end up with a 50% penalty on the money you did not withdraw.
It would make sense to withdraw the money rather than give half of it to the IRS as a penalty. So, educate yourself and stay ahead of the game. That is how you take control of your retirement savings and avoid 401(K) mistakes that many people make.
Read more: What is an RMD: Required minimum distributions made easy
9. Quitting your job before you are fully vested
Although your 401(K) might come with a match, your company’s match might be subjected to vesting schedules. This means you will need to work in the company for a given number of years before you are fully vested. Leaving before you are fully vested, will lead to losing all or a portion of your unvested employer match.
Some employers vest you right away while others vest you gradually at different time intervals. For example, you can be vested at 25% after one year of service, 50% after 2 years of service, 75% after 3 years of service, and 100% after 4 years of service. If you leave after 2 years of service, you will lose 50% of your employer match since you will be vested only at 50% in your 401(k) plan.
To avoid losing your 401(k) money when you quit, understand your company’s vesting rules and leave the job only after you are fully vested.
Read more: What does it mean to be vested in my 401(k)?
10. Accepting the default contribution rate established by the plan provider
When you open your 401(K) plan, there will be a default contribution rate already in the account. Your job is to adjust this rate in ways that maximize your tax benefits and increase your savings without putting yourself under financial stress.
A common 401(K) mistake a lot of people make is to accept the default saving rate that comes with their plans. By doing so, they never get ahead on their contributions or grow their accounts as fast as they should.
11. Not starting a 401(k) plan at at all
Avoiding a 401(k) plan when it is provided to you is one of the biggest 401(k) mistakes you can make. Not only that you will not take advantage of 401(k) benefits, but you will also fall behind on your retirement savings and increase the risk of running out of money during retirement.
12. Not doing a Rollover IRA when you quit your job
Many people ask for a 401(k) paycheck when they leave their jobs. What they don’t realize is that when your 401(k) is liquidated, that paycheck becomes a withdrawal. If you are not 59 ½, you end up paying a 10% penalty and an income tax on that money.
To avoid this common 401(k) mistake, do a Rollover IRA. A Rollover IRA is a way to transfer your 401(k) funds into an IRA while keeping all tax benefits you had with the plan. This way, you avoid paying a 10% penalty and tax on your funds prematurely.
13. Defaulting on your 401(k) loan
If you did not know it already, you can take out a loan against your 401(k) plan. Unlike normal loans from private lenders, 401(k) loans mean you are borrowing against your account and the interest must be paid back to your account. Some people consider 401(k) as withdrawing money from your account and depositing it back with interest.
When you default on your 401(k) loan, the unpaid balance becomes a distribution and the same 401(k) withdrawal rules still apply. If you default on your 401(k) loan before you turn 59 ½, you will pay a 10% penalty on the defaulted balance and income tax. That is why default on your 401(k) loans is one of the common 401(k) mistakes you should avoid at all costs. You can avoid 401(k) loan default by taking out a small amount or not borrowing against the plan.
