401k planning is a DIY (do-it-yourself) project. The IRS does their part to make it a challenging project by inserting plenty of complex rules, deadlines, and tax consequences that can trip up even the most experienced 401k planners. Here’s a quick guide to the most common 401k planning mistakes and some 401k tips and tools to help navigate your way around them.
Mistake 1 – Choosing to not participate
There’s plenty of evidence that shows that when workers are left to initiate their own 401k plan participation, many just don’t bother. Automatic 401k enrollment has become more common in recent years and has improved 401k participation rates. Still, millions who are eligible to participate in 401k’s aren’t doing so. Sometimes, non-participation may be sensible (e.g if the money instead goes to payoff high interest rate credit card debt), but for most workers, choosing not to participate in their 401k is a shortsighted move.
Remember that time is your best ally in accumulating a retirement nestegg. Younger workers, particularly, stand a good chance of accumulating substantial retirement accounts if they participate fully in their company’s 401k. But data show these workers have the poorest participation rate:
Only 70%of workers under age 35 whose employers sponsored DC plans participated in those plans in 2007. In contrast, the take-up rate among workers aged 35-44 was 82%, and the take-up rate among workers aged 45 to 54 was 83%.1
Here are a few good reasons to participate:
- Tax Benefits – the money you contribute is tax-deferred – from federal and state income taxes. If your marginal tax rate is 25%, this means you can add $100 to your 401k, by reducing your takehome pay only $75. Investment earnings in your 401k account are also tax-deffered.
- Employer Match – Many employers match your contributions up to some limit. This is free money. With a 50% match (using the above example) you could get $150 added to your 401k, by reducing takehome pay only $75.
- Autopilot Savings – 401k contributions are taken from your paycheck before you get your hands on it. By diverting even a modest sum on a regular basis, you can build substantial wealth over the long term. Moreover, you will develop a regular savings habit and benefit from the dollar cost averaging2 investment strategy.
Bottomline: If you elect not to participate in your company’s 401k, you substantially lessen the odds of having a decent retirement. Social security won’t be enough to provide a comfortable living standard and few jobs have traditional defined benefit pensions anymore. The 401k is your best retirement savings option in today’s world.
Mistake 2 – Not taking full advantage of the employer match
One of the worst mistakes 401k participants can make is not taking full advantage of employer matching dollars. Employer matches typically are capped at a percentage of pay. For example, a company may offer a dollar-for-dollar match up to 3% of pay, or, a 50% match up to 6% of pay. Whatever the employer match, it is free money and critically important to accumulating an adequate retirement nestegg. Review your employer’s 401k match policy carefully and be sure your contributions are set to get every possible matching dollar.
Use this 401k calculator to see just how important employer matching funds can be to achieving your retirement goals.
Mistake 3 – Withdrawing funds too soon
In general, 401k funds are meant to be tapped after the participant reaches age 59-1/2. There are a couple of ways you can take out funds earlier without penalty, but the rules are complex and need to be carefully followed.
- Strategy 1: 55 and Out - If you are at least 55 when you leave your job, you can take penalty-free distributions from your 401k (you still pay income taxes on withdrawals). If you use this strategy you’ll want to be careful not to rollover 401k balances to an IRA. If you transfer to an IRA you lose this option.
- Strategy 2: Substantially Equal Periodic Payments – Regardless of age, you can withdraw 401k funds penalty free after leaving employment under section 72t of the tax code. This strategy requires that distributions be made based on expected life expectancy for at least five years or until the participant reaches age 59-1/2, whichever is longer. There are three ways to compute 72t distributions. Use this 72t calculator to determine your allowable 72(t)/(q) Distribution. As an extra tip, you can take courses in a graduate tax program to gain a better understanding of your finances and retirement funds.
IRS rules regarding 72(t)/(q) and “55 and out” distributions are complex. Remember too that taking early distributions leaves less for your retirement years. Early 401k distributions should only be done after careful planing and deliberation; always consult a qualified professional before initiating an early distribution.
Mistake 4 – Borrowing from your 401k
Even if your employer permits you to borrow from your 401k (85% of sponsors do), make every effort to avoid doing so. 401k loans usually don’t make financial sense for the following reasons:
- you’re not borrowing anything – you’re simply spending your own money
- you’re losing valuable investment earnings on the money you “borrow”
- you’re losing the benefit of compounding while you have the loan outstanding
- you’re paying interest on the 401k loan with after tax dollars, thereby losing the 401k tax advantage
- you’ll pay taxes a second time when you eventually withdraw the money in retirement
- interest on the loan is not tax-deductible, even if funds are used for a home purchase
It is generally preferable to use savings or to borrow in some other way (e.g. home equity or consumer loan). A 401k loan could harm your retirement plans. Use this 401k loan calculator to see how taking a 401k loan will impact your long-term retirement stategy.
Mistake 5 – Mishandling a 401k loan
In some cases, taking funds out of a 401k is the only option available. If you are in this situation and need to choose between borrowing from your 401k or taking a 401k “hardship withdrawal”, the loan is usually the preferred route. This is because hardship withdrawals trigger a 10% early distribution penalty if you are under age 59-1/2.
In this case, it is critical to be aware of these common 401k loan pitfalls:
- if for any reason you fail to repay the loan, it will be considered a premature distribution, subject to taxes and the 10% penalty noted above
- if you quit or lose your job, you will have to pay the loan off in full, typically, within 60 days. If you can’t afford to pay the loan off, it will be considered in default and you will be taxed on the outstanding amount, plus incur a 10% early withdrawal penalty.
Taking out a 401k loan is seldom a wise financial move. But if you do take a 401k loan (and 20-25% of eligible participants do take one), be sure not to make the situation even worse.
Mistake 6 – Botching a rollover
When you separate from your employer, you may choose to rollover account balances to an IRA or to your new employer’s 401k. There are many good reasons to consider doing a rollover. But, be careful to direct that the rollover be made directly to the new retirement account’s custodian. The IRS permits rollover checks to be made out to you personally, but choosing this method can cost you dearly:
- If the rollover check goes to you, your old employer will be required to withhold 20% of the amount for potential taxes. Within 60 days, you will have to payover 100% of the account balance into your new retirement accout, meaning you’ll need make up the missing 20% out of your pocket. You can recoup this 20% when you file your annual tax return, but in the meantime you’ve needlessly tied up your money.
- If you have trouble coming up with the full amount, or simply forget to pay the money into your new account within 60 days, the situation gets much worse. The IRS will consider the entire balance a taxable distribution subject to income tax and, perhaps, the dreaded 10% early distribution penalty.
Bottomline: Keep things simple and always do direct custodian-to-custodian rollovers.
Mistake 7 – Knowing when not to rollover
A 401k rollover can sometimes cost you in other ways. We noted above that if you leave employment at 55 you could lose the option to take “55 and out” distributions if funds are rolled into an IRA. Similarly, if your 401k includes company stock that has appreciated in value, you may be better off using the “net unrealized appreciation” IRS rule to save on taxes.
Heres how you can use net unrealized appreciation to your benefit:
You’ll have to pay taxes on the company stock you didn’t rollover, but the tax will be based on the share prices you originally paid, not current market prices. Also, as you sell shares in the future, taxes will be capped at the top 15% long-term capital gains rate. For many people, this will be much more favorable than their regular marginal tax rate.
Finally, keep in mind that rollover to an IRA may also cost more in plan service fees since you lose the employer’s bulk buying power.
Mistake 8 – Waiting too long to withdraw money
Because the IRS defers taxes on 401k contributions and earnings to facilitate your retirement, they want to be sure get their share when you do retire. For this reason, there are “required minimimum distribtion” rules that madate 401k funds start being withdrawn starting the year you turn age 70-1/2.
If you fail to withdraw your RMD by the applicable deadline, you will owe the IRS a penalty of 50% of the shortfall. This is referred to as an “excess-accumulation penalty” and is one of the most onerous penalties in the IRS code.
This 401k RMD calculator can help you determine the amount and timing of your 401k required minimum distribution.
This article is one of several informative posts in the latest Carnival of Personal Finance at Fire Finance.
- Congressional Research Service, Retirement Savings and Household Wealth in 2007 [↩]
- Dollar cost averaging is the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. Eventually, the average cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time. [↩]