Friday, 1 January 2021

401k Investing Mistakes For Beginners

401k Investing Mistakes For Beginners


401k can be a financial blessing to many families. It's much easier to use a matching 401k plan offered through your employer and to open your own account elsewhere and begin investing. However, contributing money to a 401k for years doesn't necessarily guarantee a prosperous life during retirement. Surprisingly, the average 401k balance is just slightly over $100,000 which is just a fraction of what most people need to retire. The AARP estimates that around 1.2 million is needed to provide an income of $40,000 for 30 or so years. There's much more involved in ensuring a secure retirement than just signing up for a savings plan. 


Most people aren't knowledgeable about both the many ways to prepare correctly for retirement with the 401k. To help, here's a list of the most prominent mistakes that could be costing you your retirement





2. Not Taking Advantage Of A Company Match

The best thing that a 401k plan can offer is the employer matching contribution. This is basically a bonus that your company kicks in when you contribute to your retirement account which is usually based on a certain percentage of your pay. If your company contributes up to 6% of your salary, make sure you're contributing at least 6% to take advantage of that entire map.


Otherwise, it's simply money of your employer's pocketing and not paying you. These matches can double your retirement savings in some cases, but like anything, there is a catch and that's what's called vesting, rules vary, but might state they own 0% of the company's contributions during your first year of employment. 50% after two years, 70% after three years, 100% of your match after four years. 


This means that if you leave the company after just one year, none of those matching contributions will be yours. If you're considering finding a new job, you might want to make sure you're fully vested. You might decide you have to stick around at a less desirable job for a few more years to receive that money




2. Cashing Out When You Changing Jobs

If for some reason you find yourself changing jobs, do not cash out your 401k. This could result in hefty penalties due to age restrictions, in addition to large tax implications. Some funds allow you to leave money with your former employer, but many don't. If you're required to move the money, do a rollover into an IRA or into your new employer's 401k plan if possible. In a direct rollover, the funds are moved right into the new account leaving little chance for you to spend the money




3. Not Increasing Contributions Over Time

401k contributions are more often based on a percentage of your salary. So if you contribute 6% to your 401k, the contributions will rise in line with any increase in pay. But if you want to get even further ahead financially, creating the possibility of reaching financial freedom sooner, you want to boost those contributions more than that.


Say you make $75,000 a year and contribute 6% or $4,500 to your retirement plan. If you get a 5% raise, your salary goes up to $78,750 and that increases your 6% 401k contribution to $4,725. You are now making $3,750 more, but your annual contribution only went up by $225. Your cost of living doesn't change the day you get a raise, in this scenario, you could afford to increase your annual contribution to 10% which would be $7,500 annually


It might be tempting to grab that immediate gratification, but investing in your retirement instead will bring greater rewards.




4. Being Oblivious To Investment Performance

At some point, you decided how to invest the money in your 401k usually when the account was opened. The options are probably provided based on a varying level of risk. If you haven't been paying attention to how those investments have been performing compared to the overall market, start doing so now.


Every year that goes by is one year you won't be getting back. So it's important to take full advantage of compound interest. A portfolio that averages 10% over a career, in one that averages just 6% will be hugely different at retirement. The overall market averages about 10% per year, so that's a good benchmark to aim for. Remember that returns vary based on market conditions, though to understand if your returns are realistic, compare the funds that are available to you to a similar fund. If you're holding a small-cap fund, you could compare its performance to the S&P small-cap 600 over the same time period. If you have a target-date fund, compare that to an equivalent offered through a company such as Vanguard.


There's no reason to hold on to an underperforming fund. The more years you have between now and your projected retirement date, the more aggressive you can be. You might come to the conclusion that there are no excellent options available with your 401K, in which case, divert some extra cash after taking advantage of the match into an IRA or even a traditional brokerage account




5. Loading Up On Too Much Company Stock

Chances are that you get a discount on any company's stock. It's possible that this is a good opportunity but there's extra risk associated with individual stock. Experts recommend that most individual investors keep most of their money in index funds or ETS in a portion and individual stock. Say 20%. This 20% could be comprised of one single stock or multiple, but make sure you're not allocating too much of your portfolio to one stock or putting too many eggs in one basket


Many times employees are overconfident in their employer, keeping much of their retirement in their stock only, to find out that the company is filing bankruptcy. If your company runs into trouble, not only your job might be in jeopardy, but also your retirement will be as well.




6. Not Understanding The Downsides

401K isn't perfect, and it's critical to understand that. It's wise to be aware of these downfalls and alternative choices. For example, they usually have very limited investment selections. Most often between a dozen or two options. While these choices might be decent, the fees that you'll be paying are likely higher than what you'll pay with an individual retirement account where there are virtually endless investment choices. Don't underestimate the ability fees have to eat away your savings. Even fees of 1% or 2% will dramatically decrease the amount you've amassed by retirement


In addition, IRA offers the ability to invest in an individual stock if that's something you're interested in. Tax diversification is another big reason to think about spreading out your investment. Contributing to a Roth IRA will ensure you don't pay any taxes on those funds during retirement, which can be a huge advantage since 401k disbursements are taxed at ordinary income rates. Whether or not the taxes better paid now or later will depend primarily on if your income bracket is predicted to be higher or lower during retirement. If it's projected to be higher, income solely from a 401k will result in a sizeable tax bill





7. Cashing Out

Taking money from your 401k for a major purchase is one of the worst things you can do for your financial future. It can be tempting to take a lump sum out of this account to purchase a new car or expensive item instead of funding your purchase another way. But this can have a negative impact that can last your lifetime. Not only will you be forced to pay hefty fees if you withdraw before retirement age, but you could also face a big tax burden. Possibly the worst part about cashing out is that you'll be missing out on compound interest, leaving that money in there to grow allows it to snowball much quicker


Taking money out of this account before retirement should only be done after all other options have been exhausted. By ensuring your emergency fund is established with at least three to six months of living expenses it's possible to limit the likelihood of resorting to this.






Conclusion

Investing in a 401k is engineered to be simple for everyday investors. And contributing to one is a fantastic start. With some basic knowledge, you can earn substantially more passive income. Make the most of your account by saving early and often, resisting the urge to cash out, and managing how your money is invested. These small tweaks can dramatically increase your savings over time, which puts you that much closer to turning in your notice and living more comfortably in retirement  

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