7 Traps to Avoid With Your 401(k)

More and more Americans are choosing an employer-sponsored 401(k) as their preferred way to build up their nest eggs. As of 2014, an estimated 52 million Americans were participating in a 401(k)-type plan.

When used properly, a 401(k) can be a powerful tool to save for your retirement years, but there are a couple of crucial pitfalls that you have to watch out for. From high fees to limited investing choices, here is a list of potential downsides to 401(k) plans — and how to work around them.

1. Waiting to set up your 401(k)

Depending on the applicable rules from your employer-sponsored 401(k), you may be eligible to enroll in the plan within one to 12 months from your start date. If your eligibility kicks in around December, you may think that it's fine to wait until the next year to set up your retirement account.

This is a big mistake for two main reasons.

First, contributing to your 401(k) with pretax dollars allows you to effectively reduce your taxable income for the current year. In 2017, you can contribute up to $18,000 ($24,000 if age 50 or over) to your 401(k), so you can considerably reduce your tax liability. For example, if you were to contribute $3,000 between your last two paychecks in December, you would reduce your taxable income by $3,000. Waiting until next year to start your 401(k) contribution would mean missing out on a lower taxable income!

Second, your employer can still contribute to your 401(k) next year and make that contribution count for the current year, as long as your plan was set up by December 31 of the current year. Your employer contributions have to be in before Tax Day or the date that you file your federal taxes, whichever is earlier.

How to work around it

If you meet the requirements to participate in your employer-sponsored 401(k) toward the end of the year, make sure to set up your account by December 31st. That way, you'll be ready to reduce your taxable income for the current year through your own contributions and those from your employer before their applicable deadline (December 31 and Tax Day or date of tax filing (whichever is earlier), respectively).

2. Forgetting to update contributions

When you set up your 401(k), you have to choose a percentage that will be deducted from every paycheck and put into your plan. It's not uncommon that plan holders set that contribution percentage and forget it. As your life situation changes, such as when you get a major salary boost, marry, or have your first child, you'll find that your contributions may be too big or too small. (See also: 5 Times It's Okay to Delay Retirement Savings)

How to work around it

To keep a contribution level that is appropriate to your unique financial situation, revisit your percentage contribution every year and whenever you have a major life change. Don't forget to also check whether or not you elected an annual increase option — a percentage by which your contribution is increased automatically each year — and adjust it as necessary.

3. Missing out on maximum employer match

Talking about contributions, don't forget that your employer may contribute to your plan as well. In a survey of 360 employers, 42 percent of respondents matched employee contributions dollar-for-dollar, and 56 percent of them only required employees to contribute at least 6 percent from paychecks to receive a maximum employer match.

How to work around it

Employers require you to work a minimum period of time before starting to match your contribution. Once you're eligible, meet the necessary contribution to maximize your employer match. One estimate puts the average missed employer contribution at $1,336 per year. This is free money that you can use to make up for lower contribution levels from previous months or years.

4. Sticking only with actively managed funds

When choosing from available funds in their 401(k) plan, account holders tend to focus on returns. There was a time in which actively managed funds were able to deliver on their promise of beating the market and delivering higher-than-average returns. That's why 401(k) savers often choose them.

However, passively managed index funds — funds tracing an investment index, such as the S&P 500 or the Russell 2000 — have consistently proven that they can beat actively managed funds. Over the five past years, only 39 percent of active fund managers were able to beat their benchmarks, which is often an index. That's why over the same period, investors have taken $5.6 billion out of active funds and dumped $1.7 trillion into passive funds.

How to work around it

Find out whether or not your 401(k) offers you access to index funds. Over a long investment period, empirical evidence has shown that index funds outperform actively managed funds. Review available index funds and choose the ones that meet your retirement strategy. (See also: 3 Steps to Getting Started in the Stock Market With Index Funds)

5. Chasing high returns instead of lower costs

When reading the prospectus of any fund, you'll always find a disclaimer warning you that past returns aren't a guarantee of future returns. So, why are you holding onto those numbers so dearly? As early as 2010, investment think tank Morningstar concluded that a fund's annual expense ratio is the only reliable indicator of future investment performance, even better than the research firm's well-known star rating.

And guess what kind of funds have the lowest annual expense ratios? Index funds! For example, the Vanguard 500 Index Investor Shares fund [Nasdaq: VFINX] has an annual expense ratio of 0.16 percent, which is 84 percent lower than the average expense ratio of funds with similar holdings. If your 401(k) gives you access to lowest cost Vanguard Admiral shares, you would shed down that annual expense ratio even further to 0.05 percent.

How to work around It

When evaluating a fund in your 401(k), look for comparable alternatives, including index funds. To maximize the growth of your nest egg, chase funds with lower annual expense ratios and investment fees. Regardless of their performance (which tends to be better anyway!), you'll minimize your investment cost. (See also: Watch Out for These 5 Sneaky 401(k) Fees)

6. Not periodically rebalancing your portfolio

Even when choosing index funds, you still need to periodically adjust your portfolio. Let's assume that you follow this investment recommendation from Warren Buffett for your 401(k): 90 percent in a low-cost index fund, and 10 percent in government bonds. (See also: The 5 Best Pieces of Financial Wisdom From Warren Buffett)

Depending on the market, your portfolio allocation may be way off as early as one quarter. If the S&P 500 were to have a huge rally, you may now be holding 95 percent of your 401(k) in the index fund. That would be much more risk that you may be comfortable with, so you would need to take that 5 percent and put it back into government bonds. On the other hand, holding 85 percent in government bonds would make you miss your target return for that year. Forgetting to rebalance your portfolio once a year when necessary is one easy way to derail your saving strategy.

How to work around it

Many 401(k) plans offer an automatic annual rebalancing feature. Review the fine print of this feature with your plan and decide whether or not it's suitable for you. If your plan doesn't offer an automatic rebalancing feature, choose a date that makes the most sense to you and set it as your day to rebalance your portfolio every year.

7. Taking out 401(k) loans

Treating your 401(k) as a credit card is a bad idea for several reasons. Doing this:

  • Creates additional costs, such as origination and maintenance fees;
  • Becomes due in full within 60 days of separating from your employer;
  • Turns into taxable income when not paid back, triggering potential penalties from the IRS and state and local governments; and
  • May quickly turn into a bad habit: 25 percent of 401(k) borrowers go back for a third or fourth loan, and 20 percent of them take out at least five loans.

How to work around it

Treat your 401(k) as a last-resort source of financing. There are very few instances when you should borrow from your retirement account. Make sure that you go through all of your credit options and include the opportunity cost of foregoing retirement savings, including potential taxes and penalties, when comparing a 401(k) loan against another type of loan.

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