5 Dumb 401(k) Mistakes Smart People Make

By Damian Davila on 26 February 2015 2 comments

401(k)s are very important to Americans' retirements — so important, in fact, that they represent nearly 18% of the $24.0 trillion in U.S. retirement assets.

But those trillions of dollars aren't reaching their maximum earning potential due to dumb mistakes made by 401(k) owners. (See also: 4 Ways to Boost Your 401(k) Returns)

Here are five pitfalls that you should avoid in order to maximize your 401(k) nest egg.

1. Not Exploring Investment Options

401(k) participants spend more time researching options for a new car or vacations than researching their 401(k) investment choices. According to a survey, while 55% of people spend more than five hours conducting research before buying a car, only 11% of those same people spend that much time before making an investment choice for their 401(k).

Part of the problem may be that people don't understand their 401(k) investment options. About half of those people surveyed found 401(k) investment materials more confusing than health care benefits materials. Instead of doing it on your own, consider that over half of retirement plans have individual investment advice offered on a one-on-one basis.

2. Borrowing From a 401(k)

An average of 13,000 people take a loan each month out of their 401(k)s for a median of about $4,600. Borrowing from your 401(k) is bad idea for several reasons:

  • Loaned funds miss out on earnings potential, often for many years;
  • If you lose your job, your full loan balance becomes due;
  • By failing to make quarterly payments or paying back the full balance within five years, the loan becomes taxable income;
  • 401(k) participants under age 59 ½ that fail to pay their 401(k) loans are subject to an additional 10% early distribution tax; and
  • Once a remaining 401(k) loan balance becomes taxable income, that money can't be rolled over into any eligible retirement plan.

There are very few acceptable instances to borrow from a 401(k), and you should leave your retirement account as a last resort option for financing. Taking loans from your 401(k) can quickly turn into a bad habit. In a one-year study of 180,000 borrowers from 401(k) plans, 25% of them took out a third or fourth loan, and 20% of them took out five or more loans. (See also: This Is When You Should Borrow From Your Retirement Account)

3. Taking Cashouts When Switching Jobs

When you leave your job, you typically have to choose between taking a cash-out or rolling your 401(k) into a qualifying individual retirement account (IRA). While the first option is taxable, the second one is not.

Taking cashouts when switching jobs is a dumb mistake for three reasons:

  • If you're under age 59 ½, you're liable for both income tax and a 10% early distribution tax.

  • You may not get as much as you think. Some 401(k) plans have a vesting period for employer contributions. Pay special attention if your plan has a cliff-vesting schedule for employer contributions, which means that you only become eligible for employer contributions after a specified date.

  • There is a limit to how much you can contribute to your 401(k) every year. In 2015, the maximum contribution limit to a 401(k) is $18,000. This means that once you cashout monies, they may never make it back to your nest egg, without forfeiting part of your future contributions.

If you already took a cashout, still have the money, and are within 60 days from the cashout date, you still have time to roll the money over to an IRA. Don't waste time and avoid taxes!

4. Not Taking Advantage of the Retirement Saver's Credit

This is one time that you want to call up the tax man.

Even though you may feel that you're not making much money, you're still very diligently contributing to your 401(k) or other qualifying retirement plan. Uncle Sam would like to reward your hard work by providing you a tax break through the retirement saver's credit.

In 2015, the retirement saver's credit provides a tax credit based on your adjusted gross income (AGI). For example, a married couple filing jointly receives a tax credit that is:

  • 50% of 401(k) contributions when AGI is under $36,500;
  • 20% of 401(k) contributions when AGI is between $36,501 and $39,500; and
  • 10% of 401(k) contributions when AGI is between $36,501 and $61,000.

Married couples filing jointly can receive up to $4,000 ($2,000 for all other filers) in retirement saver's credit. This is one of the many reasons why it is important to start saving for retirement as early as possible. Depending on your AGI, you can take advantage of tax breaks such as this. Plus, you can always defer taxes until retirement, when you're more likely to be in a lower tax bracket.

Less taxes, more retirement savings; now that's a great money resolution for any year. (See also: 4 Money Resolutions You Should Skip This Year)

5. Self-Employed: Not Having a Solo 401(k)

Independent contractors, freelancers, and small business owners may think that they're not eligible to open a 401(k). They'd be wrong. They can open a solo 401(k), also known as an one-participant k or uni-k.

Solo 401(k) plans enable the self-employed to save up larger sums for retirement. If you're a sole proprietor and have no employees, you can contribute to your solo 401(k) as employer and employee.

For example, let's imagine that you have an S-corporation and earned $40,000 in 2014. You can contribute the maximum $17,500 allowed to your solo 401(k), and your S-corporation can contribute an additional 25% to the plan (an additional $10,000). The total contributions to your nest egg for 2014 would be $27,500.

This example shows how a solo 401(k) is a powerful way to catch up in the race for retirement. The IRS allows total contributions to a solo 401(k), not counting catch-up contributions for those age 50 and over, of up to $52,000 for 2014, and $53,000 for 2015. If your spouse earns income from your business, then you can double those contribution limits.

What are you doing to boost your 401(k) plan? Please share in comments.

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Guest's picture

Made a personal commitment to contribute 16% to a ROTH at 37yrs old to try and catch up for all the years I failed to contribute or cashed out previous 401k's like a fool for selfish reasons.

Damian Davila's picture

Better late than never! Also, remember that you can make catch-up contributions starting age 50. Another useful financial tool is that you if you make any money as a freelancer or through your own small businesses, you can open up a Solo 401(k) and make additional contributions to that retirement account. Best of luck in getting you nest egg up to speed!