How to Avoid Mistakes in Your 401(k)
The 401(k) has become the de facto method of retirement savings for many Americans. Because it is more often than not the centerpiece of one’s finances, it is important to ensure its maximum efficiency. Mistakes can be costly and they should be relatively easy to avoid given proper planning. We will look at the three biggest to provide an easy checklist for your situation.
Not Contributing Enough
Retirement is so far away and current needs always seem more pressing than putting dollars aside for later. As a result, there is a tendency to leave money on the table by not contributing enough to fully take advantage of an employer matching contribution. Each company is different, so it is prudent to check with human resources to see what the details are. It is important to be contributing at least enough to maximize that company match. To illustrate, imagine a situation where a 30-year-old making $60,000/year misses just 1% of company match for the next 35 years until retirement. At the end of those 35 years, he or she will have missed out on almost $120,000 in company contributions and associated growth. It adds up!
Assumptions: 3% raises every year and 7% annual investment return
Contributing Too Much
After ensuring that you are maximizing your match, contributing too much can be equally damaging. The IRS restricts access to money in retirement plans until you reach retirement age and will assess penalties for early withdrawal. If you are overcontributing at the expense of not having enough readily accessible savings, you risk getting hit with penalties just to access your own money. According to the IRS, Americans recently paid a total of $5.7 billion in a single year for early withdrawal penalties – that does not even factor in interest paid on 401(k) loans. A sound financial plan should have ample balance between short- and long-term money.
What is the Goldilocks amount? How much should you contribute to your 401(k)?
As mentioned in the first paragraph strive to at least fully capture the company match. If you have a well-stocked rainy day fund, target 10-20% of your annual income.
For those curious, 401(k) contribution limits for 2023 are below:
- $22,500 (under age 50)
- $30,000 (age 50 and over)
Those contribution limits apply to your Roth and/or pre-tax contributions. Our blog on Roth IRAs details some additional strategies beyond these contribution limits if your cash flow allows.
Checking Your Balance Too Much
Saving for retirement is a process that takes time. Logging in to check your balance frequently would be like planting an oak tree and measuring its growth every day. Investment decisions should be made with the head rather than the heart and checking your 401(k) too frequently can cause action based on the emotions of seeing volatility in your account balance. Once you are comfortable with your investment allocation, check in no more than once or twice per year.
It is said that a football game comes down to the fundamentals like blocking and tackling. Those teams that do them well, win. Nailing your retirement savings is the blocking and tackling of personal finance. To win the game it is essential to focus on what matters most and ensure you are doing everything correctly.
Author: David Rath, CMT, CFA
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