Retirement used to be so simple. A few generations back, an average-earning individual would work, most probably for the same company, for three decades or so. At the age of 65, retirement ensues and life out-of-work would typically involve spoiling the grand-kids, traveling the world, taking up a hobby or simply living out the golden years at a cozy retirement home.
The retirees these days have a much complex process to go through after quitting work. Life expectancy is way higher than before because of the advancements in medical technology – so one can easily live up to 70 or 80. This means having twenty years or more of life after retirement. If you’re lucky enough to live that long, how are you supposed to get the funds to support yourself?
Fortunately, would-be retirees can always rely on 401k funds to see them through their years of life after work. Here, we will take a look at the basics of 401k funds. We will also delve deep into the mistakes made by people about their 401k funds, and how they can be avoided.
401k Funds: The Basics
First, what exactly is a 401k fund and how does it work? Basically, 401k is a retirement savings plan where the employer serves as the sponsor. If you’re working for company A, your employer will be taking out a percentage off your paycheck for your retirement plan and no taxes are taken out. It’s only when funds are withdrawn from the account that taxes apply.
These plans were named after a section of the tax code introduced in the 1980s as a supplement to pensions. When the cost of running them became too much for the employers, the plan was replaced with 401ks. Through it, an employer can control how much money is placed onto the retirement fund as well as how the money is invested. Some of the usual instruments where the funds are placed are money market investments, stocks, bonds and target-date funds.
With the existing policies for 401k funds these days, a good rule of thumb to follow is to put in as much as you can on your retirement funds. Naturally, you need to take into account your living expenses but do put in as much as you can on your retirement fund. A full matching contribution to your employer’s payment is good, although a 3% match is the most popular option.
If you go for the 3% match, for example, and your salary is $50,000 – your employer will pay $1,500 and you will pay $1,500 for your 401k funds. You can definitely add more to it if you can afford it, but your employer will not pay any more than that.
Another thing that you need to know about 401k funds is that there are two types to choose from: traditional and Roth. For traditional 401k funds, wages are contributed before taxes from each paycheck. With Roth 401k funds, contributions are made using money that’s already been taxed – so there are no taxes paid upon withdrawal.
The drawback with traditional 401k is that you cannot have access to your funds before the age of 59 ½, or if you leave your employer once you reach the age of 55 or older. On the other hand, Roth 401k funds offer better flexibility because you can have free access to your funds as long as you have held the account for at least five years.
10 Common 401k Mistakes People Make
Finally, what are the ten most common mistakes made by people about their 401k funds? Take a look at the following list:
1. Cashing it out too early.
With Roth 401ks, you can gain access to your funds as long as you have held the account for the last five years. Even if this type of retirement fund does offer such flexibility, there’s no reason for you to cash out the funds too early because the point of your contribution is to save up for retirement in the first place.
Although big changes or challenges in your life could come at any point in your life which might force you to consider withdrawing from your 401k account, just remember the time that you already invested in it. By keeping the funds intact, you can rest assured that you have enough funds to see you through your retirement years.
2. Leaving investments in your former company.
If you have a Roth IRA or Individual Retirement Account, make sure to transfer your funds to it and never leave your investments with your former company. Let’s say that you transferred companies and you have a better position with a higher salary at your new company.
If you switch to an IRA, there should be no reason for you to pay those administrative fees which can add up to hundreds or even thousands of dollars. Another benefit of switching to an IRA when transferring jobs is that you can select from a variety of investment funds and increase the return of investment on your portfolio.
3. Not paying attention to fees.
A lot of people have the misconception that 401ks are free-for-all plans where they do not have to pay any fees. In fact, the opposite is true. There are costs incorporated into the pension plan which can significantly affect the balance on your savings account upon withdrawal.
The Department of Labor has made it mandatory for employers to indicate exactly what these fees are so that there will not be any misunderstandings later on. In relation to this, remember that index funds are lower than actively-managed mutual funds, something you might consider when signing up for a 401k plan for the first time.
4. Not learning about it enough.
401k is all about money and if you’re no financial expert, how can you make sure that you are maximizing your money’s growth? With something as crucial as your retirement funds, it is best to seek the advice of a trusted professional so that you can extract the utmost profit from your money with the remaining years that you have left prior to retirement.
5. Not taking inflation into account.
In 1990, stamps cost 25 cents. Today, the amount has almost doubled at 49 cents. With the price of even something as small as stamps getting a 100% increase for the past 25 years, just imagine how all the other essentials would be price-wise 25 years from now.
If you’re still way ahead of your retirement years, you should definitely take inflation into account. Explore equities and equity funds that will allow you to make adjustments with long-term inflation so that your money can actually buy what you need upon retirement.
6. Not having a plan.
While you’re at it, why not also plan your estate, budget your money and make short-term and long-term financial plans? In addition to your main retirement fund, there are other factors to consider once you leave the workplace and subsist on the 401k money that you saved over the years. It’s also critical to review your beneficiary designation in case unexpected or early death occurs.
7. Leaving the funds on autopilot.
Remember that the growth of your retirement funds still depend on current state of the market. Since your money will stay in investment instruments for a long time, it will also go through market changes so if you leave the funds on autopilot, you might not extract the maximum income for your money.
As you move closer to your retirement date, it’s better to consult a financial expert so that you can get the money that you expect upon retirement date and not have to deal with a smaller amount than what you originally intended.
8. Trying to play catch up.
Your kids can always borrow funds for their student loans and pay for them later, but you will never know if they will support you upon retirement. As such, you should take it upon yourself to save up enough money for your retirement years and start as early as possible instead of playing catch-up.
9. Failure to re-balance.
It is best to look for long-term investment instruments for your 401k plans, preferably ones which cannot be endangered even if the market goes down. Another option is for you to frequently rebalance your asset allocation. This way, any underperforming assets can be transferred to more successful investments. This will maximize your 401k’s earnings upon retirement
10. Failure to decide upon asset allocation.
Another mistake that holders of 401k accounts make is not deciding upon asset allocation. Most companies offering these retirement plans have more aggressive investment steps during the first few years. They become less and less aggressive as the owner of the plan nears retirement. This way, you can just sit back and let your money grow, while being confident in the fact that you will have enough funds to last you through your retirement years.
By steering clear of these mistakes, you can maximize the growth of your 401k funds and have enough money to spend on your retirement years.