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Don’t Make These Common 401(k) Mistakes

It cannot be denied: The 401(k) plan has replaced traditional pension and profit-sharing plans in the majority of companies throughout the country. This type of plan still enables you to save sufficient funds for retirement through salary deferrals … if you are careful.

Unfortunately, some employees are not benefiting from 401(k) offerings or are making costly mistakes. Here are a few examples of what we mean.

1. Failure to participate: If an employee fails to participate in the plan, he or she may miss out on the match that the employer is providing for elective deferrals. For instance, suppose your employer offers to provide a matching contribution of 50 cents on the dollar. If you are able to defer $5,000 to your 401(k) this year, your employer must kick in $2,500 more. That’s an extra $2,500 without doing any extra “work.”

Moreover, these contributions can grow over time, due to the power of tax-deferred compounding. If you have a relatively long time horizon and contribute to the plan each year, you can build a sizeable nest egg for the future. Note: The maximum dollar amount that may be deferred to a 401(k) plan for 2008 is $15,500; $20,500 if age 50 or older. (These figures are unchanged from 2007.)

2. Errors in diversification: The most obvious type of diversification mistake is the failure to do it at all. Just as you would be advised to diversify within your personal portfolio, the same holds true for your retirement plan holdings. Other mistakes include “over-diversification” such as spreading out 401(k) dollars in every possible mutual fund or other investment option and “under-diversification” where a disproportionate portion of the pie is devoted to a single investment or type of investment. It is important to find the proper balance.

Normally, an allocation among stocks, bonds and cash should be based on your age, your expected retirement age, the amount you are contributing each year and your tolerance for risk.

3. Early distributions: Your 401(k) plan is meant to be a savings vehicle for retirement. However, participants often cannot resist taking out distributions, especially if they are changing jobs. As a general rule, a distribution made prior to age 59½ is subject to a 10% penalty tax on top of the regular income tax that is owed.

If you switch jobs and roll over funds from your 401(k) to an IRA or another qualified plan, the rollover is exempt from current income tax if completed in a timely fashion.

4. Unnecessary loans: Along the same lines, you should be discouraged from taking a loan from your 401(k). Even though you will effectively be paying yourself back, it will be more difficult to meet your objectives for retirement. You will not have access to the funds you could have earned if the principal had remained intact.

Of course, borrowing may be necessary in an emergency, but this should generally be considered a last resort.

Practical approach: Don’t fall prey to these 401(k) mistakes. Use a dose of common sense to maximize the possible benefits.

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