401(k) Gotchas’ to Avoid

The biggest mistake people make with 401(k)s is not participating in them.   Many companies match up to a specific percentage of contribution. That’s free money you wouldn’t have any other way. For instance, if your company matches three percent, for every hundred dollars you make, you’ll put away $3.00 and your company will do the same.  Since you put invest the money pretax, if your tax rate is 25 percent, you’ll only see a difference of $2.25 in your paycheck, even less if you pay a higher rate or have state taxes withdrawn. However, you’d have $6.00 in your retirement savings.  You’ve almost instantly tripled your investment with no risk. You can’t get that type of guaranteed return anywhere.

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People who invest in 401(k)s when they’re young often make the mistake of being too conservative and those who invest in it close to retirement frequently try to catch up by going with a more aggressive blend of investments. Both are the wrong approach. The market rises and falls continuously. The younger you are the more chances you can take, since you won’t need the funds for a while and have time to allow it to rise if the value of the investment drops. The closer you are to retirement, the less time you have to recoup lost funds, so switching to a more conservative portfolio is important. Some 401(k)s have funds geared to specific ages.  Putting at least some of your money in these can help you stay on track.

As with any type of investing, a huge mistake many people make in a 401(k) is not diversifying. While an investment option may be going gangbusters, there is no guarantee it will continue.  Asset allocation and rebalancing is a financially sound concept used by many planners. Initially, you allocate a specific amount to stocks, bonds and fixed investments, such as an interest bearing account. The younger you are, the more you invest in stocks. If you want to take a chance on a risky fund, only allocate 10 percent to it.

Let’s say you’ve invested 40 percent in stocks, 10 percent into your risky fund, 25 percent into bonds and 25 percent into a fixed asset. At the end of six months, your stocks and risky asset has grown substantially more than the other two investments—in fact, bonds have dropped. Now your investment is 50 percent stocks, 20 percent into your risky fund, 10 percent in bonds and 15 percent in the fixed fund. You reallocate funds from the stocks and the risky fund to create your original blend.  You’ll be selling off the stocks and the risky fund high and buying bonds low, which is the goal of investing.  If you’re intimidated by investing, consider a fund based on asset allocation. In the same line of thought, if the fund drops, don’t sell! You only lose money if you sell a fund when it’s low. Instead, you should be buying when it’s low or at least staying put, particularly if you’re young.

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Abandoning a 401(k) after you leave your employment and not making arrangements to move it, or worse yet, cashing it out, is a huge mistake many people make. While the investment is safe with your previous employer and you can leave it in the plan, many people often forget about it. Moving without notifying the plan of your address change often means you quit receiving statements and before long, it’s not even a memory.  Cashing out the plan when you leave is even worse. Not only do you disrupt your retirement savings, you’ll pay taxes and a high penalty on removing the funds. The solution to this problem is easy.  Either roll your previous plan into one with your new employer or roll the plan directly into a rollover IRA.