Money Girl explains how to steer clear of 5 costly 401(k) mistakes that could hurt your personal finances.
This is the second episode in a 2-part series about how to make the most of your retirement account and avoid costly mistakes that end up hurting your finances.
In Part 1 of this series, you learned the basics of traditional and Roth IRAs and 5 common missteps people often make. Now we’ll cover how to steer clear of 5 more mistakes that you might make with a workplace retirement account, like a 401(k) or a 403(b).
What Is a Workplace Retirement Account?
If your employer offers a retirement plan, never take it for granted. It’s a really valuable benefit that allows you to save for retirement and reduce your taxes at the same time.
If you enroll in a retirement plan at work, a portion of your wages gets deducted from your paycheck and deposited directly into your retirement account. This is a smart way to save because money is set aside before you ever see it and get tempted to spend it. You choose from a menu of investment options that fit your risk tolerance from very conservative to aggressive growth.
You’ve probably heard of a 401(k), which is the most popular type of employer-sponsored retirement plan. Its sister account, the 403(b), is offered by many non-profit organizations--such as schools, churches, and hospitals--and is similar in most ways.
For 2014, you can contribute up to $17,500 or $23,000 if you’re age 50 or older, to a 401(k) or 403(b). Your contributions aren’t subject to income tax until you make withdrawals in retirement. However, payroll deductions for Social Security and Medicare still apply.
Taking early withdrawals from any type of retirement account is expensive. So never contribute money that you might need before the official retirement age of 59½.
Some retirement plans allow “hardship distributions” for certain qualifying events, such as avoiding foreclosure, paying for college, or paying funeral expenses. But even those distributions are subject to a 10% early withdrawal penalty, plus ordinary income tax.
In addition to sheltering your money from taxation, workplace plans are protected from creditors if you, or your employer, declare bankruptcy.
Now that we’ve hit the highlights of workplace retirement accounts, here are 5 costly mistakes to avoid:
Mistake #1: Sticking with a Default Contribution Amount
Many employer-sponsored retirement plans automatically enroll employees and withhold a default contribution amount from their paychecks, unless they opt out. Studies have shown that signing people up this way gets more people to participate and save for retirement.
However, the downside of automatic enrollment is that many people save less than if they had signed up and chosen a retirement contribution amount on their own. This is because the default contribution level is typically very low, such as 2% of income.
While saving 2% for the future is certainly better than zero, don’t assume that your retirement plan’s default savings rate is high enough. Everyone should be saving at least 10% to 15% of gross income to pay for a comfortable retirement.
Additionally, sticking with the default contribution rate may be too little to max out matching funds that an employer may offer, which brings us to the next mistake...
While saving 2% for the future is certainly better than zero, don’t assume that your retirement plan’s default savings rate is high enough.
Mistake #2: Not Maxing Out a Match
Imagine this: Your employer wants to give you a raise, asks for nothing in return, and you turn it down. Not likely, right? Well, that’s exactly what’s happening if you don’t take advantage of employer matching.
Let’s say you earn $50,000 a year and get a 3% 401(k) or 403(b) match. If you contribute $1,500 a year or $125 a month, your employer will also contribute $125 a month. That’s an impressive 100% return on your money even if you have no investment growth!
Your retirement plan may require you to be enrolled for a certain period of time before you own all of the matched contributions and growth, which is known as vesting. If you leave the company before you’re fully vested, you may not receive the entire company match. However, you’re always 100% vested in the contributions that you make from your paycheck.
Mistake #3: Ignoring the Roth Option
In Part 1 of this series, I covered the Roth IRA. Did you know that many workplace retirement plans also have a Roth option?
Just like with a Roth IRA, you fund a Roth 401(k) or 403(b) with after-tax money. When you make withdrawals after age 59½, neither your contributions nor earnings are subject to tax. But unlike a Roth IRA, which isn’t available to high earners, a Roth 401(k) or 403(b) is available to all plan participants because threre are no income limits.
Your decision to take advantage of a Roth retirement account should include considerations about your current and future tax situation. For instance, if you believe there’s more benefit to paying tax on current-year contributions, instead of later on in retirement, you’re better off with a traditional retirement account. But if you believe that you’ll pay more tax in retirement than you do now, it makes sense to pay tax earlier rather than later with a Roth.