Hopefully everyone who has access to a 401(k) is contributing to a 401(k). To not do so is a mistake you don’t want to realize when you’re old and grey. The government isn’t going to save you because, with a large Social Security funding gap, the government is having a hard time saving itself. In fact, the government will probably hurt your ideal retirement life by either raising the retirement age limit for receiving Social Security and Medicare, raising taxes, or both.
I only have 13 years of experience contributing to my 401(k) because I rolled it over to an IRA two years ago. But 13 years is long enough to realize plenty of things I’ve done wrong. My 401(k) mistakes have cost me probably close to $150,000 since I started, which equates to around 35% of my 401(k) amount when I left Corporate America. In other words, instead of having $400,000 in 2012, I could have had $550,000 had I optimized better.
There’s a chance you’re making the same 401(k) mistakes that I’ve made. This post is a reflection of such mistakes as well as the mistakes I’ve witnessed personal finance consulting clients and readers make throughout the years. Hopefully this post will make you richer down the road as we analyze each mistake and solve them together!
TOP MISTAKES HURTING 401(k) RETURNS
1) Being an uninformed bugger. You get a job and you’re so excited to start working that you don’t bother to read the employee handbook that describes all your benefits. It’s very easy to overlook benefits such as health care, paid time off, sick leave, retirement savings plans, and sabbaticals when you are young because what do you care? You’ve got your whole life ahead of you to save for the future. It’s hard to think about ever burning out at work because you’ve only just begun.
The first thing you should do is thoroughly understand all your benefits. Once you’ve read your employee handbook, make an appointment with HR or your benefits specialist to have them elaborate on every section of the handbook and answer follow-up questions. So many people young and old are distracted with all that comes with a new job that they forget to immediately start contributing to their 401(k)s.
When I was making a $40,000 base salary in Manhattan back in 1999, I only contributed about $3,000 to my 401(k) that year because I just started work in July (graduated in May). If I had studied my firm’s 401(k) plan, I would have known I could have maxed out to $10,500 by increasing my pre-tax contributions and contributing some of my year-end bonus as well to catch up. But, who has time to figure out such things? I was going to Series 7 class for five hours a day, working non-stop afterward, then attending team building events with my classmates until the late evening.
2) Not staying on top of your investments. The world and your needs are changing all the time. As a result, it’s important to stay on top of your investments. I highly recommend everyone rebalance at least twice a year, even if only minor tweaks are done, because such activity forces you to study up on what you have in your 401(k). “Setting it and forgetting it” is not a great investment strategy. (See: How Often Should I Rebalance My 401(k)?)
Everything was going great in 1999 with tech and internet on fire. Nobody could lose until the NASDAQ imploded one fateful day in the spring of 2000. After reading all about my firm’s retirement benefits, I was diligently maxing out all I could in a hyper-growth Janus Tech fund that could do no wrong… until it blew up. I didn’t bother with diversification, cash management, or understanding bonds. I paid the price, but luckily I didn’t have that much money invested in my 401(k) at the time. It’s good to learn your mistakes when you’re still young and poor!
3) Not maxing out your IRA and 401(k) if both are available while you can. If you have the ability to max out your IRA and your 401(k), do it. In 2014, the maximum amount of money you can make to contribute the maximum pre-tax contribution of $5,500 is only $59,000 for an individual. After $69,000 (between $59,000 – $69,000 there is a phaseout), you aren’t allowed to contribute any IRA pre-tax money at all. How’s that for setting a low bar for income discrimination?
Of course maxing out $17,500 in your 401(k) and $5,500 in your IRA will be very difficult if you only make $59,000 or less, but give it a go because you’ll be saving $23,000 for your future. The deduction won’t hurt as bad because it’s a pre-tax deduction. Surely many of you can live off $36,000 in gross income when you’re still young and resourceful.
Back in 1999, the maximum contribution to an IRA was only $2,000. Even when I was only making $40,000 in expensive Manhattan, I scoffed at contributing $2,000 because I felt $2,000 would do very little for my retirement. Furthermore, I felt that I would leave behind an orphan IRA fund once my income surpassed the income limit threshold. In retrospect, I should have just contributed $2,000 in 1999 when I had the chance. Something is always better than nothing when it comes to retirement funding.
4) Trading way too much. It’s been shown time and time again that trading in and out of securities is a bad idea. Not only will you never be able to time the market correctly, you’ll incur unnecessary trading fees as a result. The time you spent trading your 401(k) is time you could have spent becoming a better employee. Getting promoted and paid is where the real money is for the first 20 years of your career.
Trading too much was my biggest problem. I worked in the Equities department of a Wall Street firm so stocks were all I thought about and talked about every day. I couldn’t help but trade my portfolio, like a bartender who can’t help but sip on his best concoctions until he gets a little too tipsy for his own good. Some trades made a killing. Other trades underperformed miserably. At the end of each year I’d compare my gains to my losses, and most of the time the difference would be negligible (i.e., under $20,000). For years in a row I’d reach Fidelity’s rebalancing limit and get a warning. Thankfully there was a trade limit; otherwise I would have kept on going.
If you have trading tendencies like me, try and keep your rebalancing to once a quarter, max. I can promise you that your actions won’t make much of a difference over the long run, and your performance will suffer at the margin if you don’t follow my advice. But again, the real money is to be made by doing well in your career. And even if your 401(k) reaches meaningful amounts in the hundreds of thousands of dollars, you’re still better off keeping trading to a minimum and focusing on your career.
5) Borrowing or withdrawing from your 401(k). There is a reason why the government withholds taxes from us throughout the year. Humans cannot be trusted to do the right thing with money! Can you imagine the chaos that would ensue if the government allowed its citizens to pay everything they owed at the end of the year? Half of us wouldn’t come up with anything because we’d have spent all our money. 40% of us would probably fudge our taxes to the point where we’d argue to pay much less. Only about 10% of us would actually be good boys and girls and pay 100% of what the government tells us we owe.
Borrowing from your 401(k) puts a huge drag on performance. If you had borrowed from your 401(k) in 2013, not only would you have missed up to ~30% in returns, you would have had to pay interest on those borrowings. At least you are paying interest to yourself. If you permanently withdraw from your 401(k), not only will you pay normal income taxes, you’ll also pay a 10% penalty on your money.
Of course if the choice is between death and borrowing from your 401(k), then pillaging the 401(k) is a better course of action. But hopefully no Financial Samurai reader will ever be that tight on money, because besides contributing to a 401(k), everyone should also be saving in post-tax investment accounts as well. As soon as you let yourself borrow from your 401(k), the floodgates will open and you’ll want to borrow every time there is an “emergency.” (See: Only Petulant Fools Borrow From Their 401(k))
6) Not contributing once you’ve left your job. A job change is generally a stressful time. You could have lost your job due to a layoff, or you could have found a new exciting job opportunity. Whether you are self-employed or a new employee, it’s important to continue the habit of contributing to your 401(k) or any pre-tax retirement savings vehicle while carefully monitoring your cash flow.
When I left my job in 2012, I was feeling very content to finally get out of the rat race. I wanted to spend all my free time writing and traveling, so that’s what I did. I didn’t bother researching things such as the SEP IRA or KEOGH 401(k) until the very end of the year because I had already rolled over my 401(k) into an IRA. The last thing on my mind was contributing to my retirement because I was already retired. I wanted to spend my money, not save!
But when you’re ahead, you might as well keep on pressing ahead because who knows when bad things will happen. It’s better to be conservative in your retirement needs with too much money than have too little. (See: Should I Rollover My 401(k) Into An IRA?)
7) Converting your 401(k) into a ROTH IRA. It’s one thing to contribute to a ROTH IRA for tax diversification purposes after you’ve maxed out your 401(k). It’s another thing to convert your 401(k) into a ROTH IRA if you reside in one of the highest taxed states in the country. If you live in California, Wisconsin, New York, New Jersey, Connecticut, Pennsylvania, or Maryland, please consider delaying your ROTH IRA conversion until you move to a lower income tax state such as Florida, Wyoming, Washington, Oregon, Tennessee, or Louisiana. If not, you will be paying 3% up to 10% more in taxes than you otherwise should.
The greater your 401(k)’s value and the higher your taxes, the more you should consider never doing a ROTH IRA conversion. Simply rollover your 401(k) into a traditional IRA without paying taxes up front. If you’re a young buck in a low income tax bracket who sees great earnings potential ahead, you’re less at fault for converting to a ROTH IRA. Just know that as soon as you give up your free will, you might as well give up your freedom as a US citizen. The government is extremely wasteful. The more you pay in taxes, the more you will realize this truth. (See: Disadvantages Of A ROTH IRA: Not All Is What It Seems)
8) Paying way too much in fees. You know who are the richest fund managers in the world? Those who not only gather the most in assets, but charge the most in fees. Given that The Vanguard Group runs about $2.75 trillion dollars, you’d think Jack Bogle, the founder, would be a mega-billionaire, right? Wrong! Jack revealed to the public that his net worth is in “the low double digit millions.” Let’s assign a $100 million net worth to Jack due to his humility. $100 million is nothing compared to so many hedge fund managers and all-star mutual fund managers who run much less. Steve A. Cohen of SAC Capital – who had one of his fund managers convicted of insider trading – got paid over $2 billion just in 2013. That’s 23X more in one year than what Jack Bogle, at 83, has taken a lifetime to accumulate.
The money management business is one of the best businesses in the world because it is so scalable. It doesn’t take a person more brainpower to manage a $100 million portfolio than it does to manage a $1 billion portfolio. You, of course, want to invest in good money management businesses as an investor. But as an investor in public equities, you should be thinking about investing in funds that charge the lowest fees.
For 11 years, I never once looked at the fees I was paying in my 401(k) until I discovered Personal Capital in 2012. When I ran my 401(k) through Personal Capital’s 401(k) Fee Analyzer tool, I was absolutely shocked to discover I was paying $1,700 a year in fees. What’s worse, Personal Capital smartly translated the fees into how many fewer years I would be able to enjoy retirement. I became irate enough to change. One fund was charging 1.6%, so I quickly found a matching Vanguard fund that charged only 0.2%. I also changed a lot of my portfolio into ETFs.
Below is an example of the 401(k) Fee Analyzer tool highlighting exactly how much in fees I would be paying for my funds a year. Not shown are my individual stocks (which have zero fees) below the Funds section. To run your 401(k) or rollover IRA through Personal Capital’s free tool, simply sign on to your dashboard, link your account(s), go to the Investment Tab on the top and then click 401(k) Fee Analyzer.
MAXIMIZE INVESTMENT RETURNS BY TAKING ACTION
It’s unbelievable that almost half of America’s workforce of 100 million do not own any retirement account assets at all. If you’re one of them reading this post now, please follow step one of this post and immediately schedule an appointment with your benefits manager to see what they can do for you. I don’t want you going through your career not knowing that you could have been contributing to your 401(k) or IRA all this time.
For the millions of you who have the opportunity to contribute to a 401(k), please don’t waste your opportunity to contribute the maximum amount every single year. Often times your employer will provide you free money through a match. If you’re at a firm long enough, some employers will even inject year-end profit sharing contributions like my old employer did when I was a Director. Contributions add up over time to the point where the returns in your 401(k) could conceivably overshadow the income you make from your job.
Stay the course and know that every contribution makes your future retirement a little bit better. X-ray your 401k for excessive fees and keep track of your finances. the better you can track your finances, the better you can optimize your finances.
Updated for 2017 and beyond.