401(k) Mistakes to Avoid

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Fees and penalties for your 401(k) can often be avoided if you understand how your 401(k) plan works. You can also take advantage of employer contributions and tax breaks once you figure out how to qualify.

Take care to avoid these 401(k) mistakes:

Here's how to fix several common 401(k) problems.

A Low Default Savings Rate

Many employees are automatically enrolled in a 401(k) plan, typically at the default savings rate of 3%. But sticking with this low savings rate could be a mistake.

"That 3% is not enough," says Shannon Nutter-Wiersbitzky, head of participant strategy and development at Vanguard. "If a younger person could start at the 12% rate, they are certainly going to benefit tremendously from the benefit of compounding over time."

If you can't save that much at the beginning of your career, aim to increase contributions each year. "It's typical that you would start at potentially a lower percentage and then increase that over time," Nutter-Wiersbitzky says. "If you generally get your raise at the end of the year, set your 401(k) to automatically increase. You won't feel it as much in terms of what is being saved for you out of your pay."

Missing Out on the 401(k) Match

Find out if your employer provides a 401(k) match, and make sure you save enough to qualify for the maximum possible match. One common 401(k) match formula is 50 cents per dollar saved up to 6% of pay. In this case you would need to save at least 6% of your salary in order to claim the full match.

"A 401(k) match anywhere from 4% to 6% of pay is typical," says Gregg Levinson, a senior retirement consultant for Willis Towers Watson. "It might require 8% deferral (of your pay) to get the full 4% (match)."

Failing to Maximize Tax Breaks

Workers defer paying income tax on the money they contribute to a traditional 401(k) plan. Participants can delay paying taxes on up to $19,500 in 2020. Those age 50 and older can make catch-up contributions of up to an additional $6,500. A 55-year-old in the 24% tax bracket could reduce his income tax bill by $6,240 if he maxes out his 401(k) plan.

"There is a big tax advantage if you contribute to the max allowed," says Lavina Nagar, a certified financial planner and president of Maya Advisors in Palo Alto, California. "If you can stretch yourself and save the full $19,500, that is the ideal situation." Income tax won't be due on the money in your traditional 401(k) plan until it is distributed from the account.

Automatically Accepting the Default Investment

Workers who are automatically enrolled in a 401(k) plan are invested in a default fund selected by the plan sponsor. The most common default investment is a target-date fund, which typically contains a mix of stocks, bonds and cash that grows more conservative over time. However, the fees, underlying investments and rate at which the fund grows more conservative won't be an ideal fit for all employees. Take a look at the other investment options in your 401(k) plan before sticking with a target-date fund.

Paying Excessive 401(k) Fees

While some 401(k) plans negotiate for low costs on behalf of their employees, others are riddled with expensive funds and excessive fees. However, you can move your money to lower-cost funds within your 401(k) plan. Your 401(k) plan is required to send each participant an annual 401(k) fee disclosure statement that lists how much each fund in the 401(k) plan costs to own in a single chart.

"There are disclosures that have to come with those investments that detail the fees," says John Scott, director of the The Pew Charitable Trust's retirement savings project. "You should be able to get that information from your human resources person or the plan service provider or the mutual fund provider." Check this document each year to see if there are lower-cost funds in the 401(k) plan that will meet your investment needs.

Leaving the Company Before You are Vested

You don't get to keep employer contributions to your 401(k) until you are vested in the account. Some 401(k) plans immediately vest company deposits, while others require several years of job tenure before you can keep any of the 401(k) match. There are also graduated vesting schedules that permit employees to keep a portion of the 401(k) match based on their years of service at the company, and some employers require five or six years on the job before employees qualify for the entire 401(k) match.

"Vesting can be immediate or vesting can stretch over a period of time," Nagar says. "If you move you might leave something on the table, and that should be part of your negotiation for the new job."

Triggering the 401(k) Early Withdrawal Penalty

Cashing out your 401(k) plan before age 59 1/2 (or in some cases age 55) will typically trigger a 10% early withdrawal penalty in addition to the income tax you will owe on the distribution. A $5,000 withdrawal at age 50 will result in a $500 early withdrawal penalty and another $1,200 in income tax for someone in the 24% tax bracket. However, 401(k) participants who have been impacted by coronavirus costs are eligible to take penalty-free emergency withdrawals in 2020 and can pay the income tax over three years.

Initiating a 401(k) Loan

If you need access to your savings before retirement, account owners are typically allowed to take a 401(k) loan of as much as 50% of the vested account balance up to $50,000. The CARES Act temporarily increases the 401(k) loan limits to 100% of the vested account balance up to $100,000 for account owners facing coronavirus costs. Loans generally must be paid back with interest within five years. However, 401(k) loans charge a variety of fees, and you miss out on the investment gains you could have earned in the account.

"It should be a last resort because the interest isn't deductible and you're tapping into a retirement asset," says David Clarken, a certified financial planner for FWI Wealth Management in Atlanta. If you leave your job, the loan balance must be paid back by the due date of your federal income tax return. Loans that aren't repaid on time are considered distributions, and taxes and penalties may apply.

Forgetting to Take 401(k) Distributions in Retirement

Withdrawals from your 401(k) are typically required after age 72. The penalty for missing a required distribution is 50% of the amount that should have been withdrawn. But you don't need to wait until age 72 to take retirement account distributions. Some retirees start withdrawals during their 60s, which allows you to space out the tax bill and in some cases pay a lower tax rate. Retirees will be allowed to skip their 2020 required minimum distributions due to provisions of the CARES Act.

Ignoring Old 401(k) Plans

When you change jobs, you can generally leave your retirement account balance in the 401(k) plan. You might want to maintain a 401(k) plan with a former employer if the plan has especially good investment options, low costs or contains company stock.

However, if you have multiple 401(k) plans at several former employers, you can simplify your financial life by consolidating accounts. Some workers open an IRA and roll their 401(k) balance into it each time they change jobs. Moving your money to an IRA maintains the tax benefits while also giving you a wider range of investment options.

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