I’m Robert from The College Investor and I’m swapping blogs with Kevin today for the Yakezie Blog Swap! You can head over to my site to read Kevin’s pet peeve about Roth IRAs.
My biggest financial pet peeve has to do with 401(k)s and how the government tries to make it easy to save, but then gives people every way possible not to save. I hear all kinds of things at my day job: “I don’t know if I should start my 401(k)” or “Maybe I will just take a 401(k) loan to pay off my credit card debt”, or the very worst “I will just withdraw from my 401(k) to buy this unnecessary material object”.
Just hearing all of these things makes me cringe, and I do my best to educate, but should it really be up to the few people here and there to prevent others from making huge financial mistakes? I don’t think so, and here are some easy fixes, if anyone will listen:
Mandatory Enrollment
My first issue with 401(k)s is that most of them come with a matching contribution from the employer, yet so many employees are leaving this free money on the table. My employer matches dollar-for-dollar, up to 5% of my pay. Just by enrolling in my 401(k) and contributing 5% of my pay, I get an instant 5% raise. Who doesn’t want free money!?!? If your employer offers a match, it is a huge mistake to not get all of the free money you are eligible for. According to a survey by Hewitt Associates, 22% of 401(k) participants eligible for a company match don’t contribute enough to get the maximum amount.
A simple solution for all parties involved is mandatory enrollment with an option to opt-out. So, if you get a new job, you are automatically enrolled into the 401(k), if offered. In a study by Vanguard, it was found that opt-out programs had a 96% participation rate, where opt-in programs only had about a 58% participation rate. Yes, the employer might not like it as much (they have to shell out more to their employees), but it is huge for the employees, and it will most likely save the government money down the road, with more individuals being able to support themselves in retirement.
Stop the Borrowing
Beyond not participating in your company’s 401(k), the next biggest mistake you can make is taking a loan from your 401(k). Some people say, “Well, you are technically borrowing from yourself, and paying yourself back with interest…” And yes, this is true. In fact, in 2010, 18% of 401(k) plan participants took out a loan. But taking out a 401(k) loan is detrimental to your financial future!
First, when you take out a loan, you stop investing that money, and lose any potential gains. While this may not seem like a big deal, over 30 years, $2,000 can compound into $40,000! That’s an expensive loan!
Second, if you lose your job, or otherwise become ineligible for the 401(k), any outstanding loan balance becomes due with a set period of time (usually 30 to 60 days). Don’t have the money to pay? Well, the remaining loan balance is treated like a withdraw, and it is subject to tax as income at your current tax rate (say 25%), plus a 10% early withdraw penalty. Say you took a $2,000 loan, well you would still be on the hook to pay Uncle Sam about $550! Didn’t have the original $2,000,? Well, I hope you at least have this, because I doubt Uncle Sam will be as nice as your employer.
Finally, what are you taking a loan out for anyway? To buy stuff? To pay off debt? If you have to get a 401(k) loan to buy something, you probably can’t afford it, so don’t buy it. See the first reason why you should get a loan, and see what it will end up costing you over 30 years. Second, if you are using the loan to pay off debt, it is important to realize that retirement savings are not allowed to be touched in bankruptcy. So, if you are that indebted that you are considering this, DON’T! You should figure out another solution to your debts, or you should declare bankruptcy. At least when it is over, you will still have your 401(k) savings!
This is a program that federal government should just eliminate. There is no reason to allow employees to take a loan from their 401(k)s. It just gets people into financial trouble.
Early Withdrawal
This is another mistake that so many people do! Similar to getting a loan, some people just want to cash in their 401(k)s! The most common time this happens is:
- You leave your job
- You need the cash
If number 2 applied to you, see the pitfalls of taking a loan above. If you withdraw early, you will be subject to taxes and penalties, and it was probably better for you to keep the money invested to start with.
If number 1 applies to you, you should consider the following options:
- Just keep the money invested in your old employer’s plan if you have over $5,000: There is no harm leaving the money there. The money is not actually with your employer, but an investment firm hired by your employer.
- Move the money to your new employer’s plan: this is becoming more common, simply because it is convenient for the account holder. For individuals who switch jobs every 3 to 5 years, you could end up with 6 or 7 plans by the time you retire. By moving the plan with you, you can keep everything consolidated in one spot.
- Do a direct rollover into an IRA at a discount brokerage: this option gives you the most flexibility and investment options. You have complete control of your investments, and the investments are still tax-deferred and protected in bankruptcy.
These options are a lot smarter than just taking the cash! Too bad it is not all that clear how to go about doing this when you switch jobs.
Not Being Diversified
For most 401(k) plan participants, this plan is the sole investment vehicle they have. They also just set the investments and forget about it, and many people don’t realize, but most companies give the employer match as company stock, not just cash. As a result, after years of investing, most 401(k) participants are not diversified. Instead, they have big holdings of company stock and other funds.
Diversification is not letting any single stock account for more than 5 to 10% of your portfolio. Say something bad happens to your company. If you have a large holding, you could see your retirement savings cut in half!
The simple solution is to re-balance your 401(k) annually or semi-annually. Yes, this is more work than most plan participants currently do, but it can amplify your returns in the future, and save you from potential losses.
Summary
401(k)s are great plans. They usually come with an incentive (a company match), they are tax-deferred, and are easy to setup. However, there are so many pitfalls and mistakes that can be made, that it is important to really think about any decisions that are made with the plan.
– The College Investor
Kevin’s Take: I only have one pet peeve about 401ks, and it’s people who don’t contribute when their employer matches. I can understand the desire to avoid using an instrument that heavily penalizes you for taking money out early, but if your employer matches, then you can take early withdraws, pay taxes and penalties, and still have more money than you would have if you didn’t contribute (because of the employer match). I contribute to my 401k because I’m happy to let that money sit for 40 years, but I also understand people who don’t want to do that.
The biggest mistake is not adding contributions (with the related doing the opposite – withdrawing them early). Making the default option to set 5% (with matching the first 5%) is the best thing a company can do. The next best thing a company can do is give good options – don’t accept high expenses on the funds (use Vanguard…).
My 401k peeve is the 16.5k limit. Why can’t I contribute more if I want to? I need more tax protection.
@John – I agree that there should be some standard. My company matches dollar-for-dollar up to 5%, but then there are others who match 50% up to 3%, etc…it gets kind of frustrating!
@Retirebyforty – Stop being a deadbeat taxpayer! Just kidding! I do think there doesn’t need to be a limit and the government will eventually get their tax money when you withdraw.
Great article, Robert, and I like the mandatory enrollment idea!
I couldn’t agree more, especially this one: “What are you taking a loan out for anyhow? ” My hubby left a job about 10 years ago, we rolled over his IRA into an IRA, and 10 years later, this retirement money has grown substantially.
@Eliza – Thanks! I think it will put everyone on such a better financial footing!
@ Barb – I cannot believe how many people think about and do take out loans from their 401k!
Very good post here! I agree that employers should automatically enroll their employees in 401k plans upon starting their jobs. Most do not charge inactivity fees, so the account could stay open without being used if the employee really didn’t want it.
I get so frustrated with the terrible fund options with my company! I think the lowest fees are around .7% I know it doesn’t seem that bad, but compared to Vanguard, this is pretty terrible 🙁
@ Jacob – So true! There are so many options available for companies that are relatively costless, but they just don’t do it.
@ Jon – My current 401k is managed by Hewitt, and they are really terrible. They offer horrible funds and charge outrageously. I wish my company would get it together on this one!
I agree about the poor fund choices and what’s more, the lack of good advice given to the participants. I was on our company’s 401(K) committee meeting and it distressed me to see how even many of the young people are invested solely in the money market, and many don’t contribute enough for the full employer match. And many of our funds have high expense ratios.
At my age (62), I was eligible for a tax-deferred rollover from my 401(k) to my Vanguard IRA, which is an option anyone over 59.5 should look into. I kept just a small balance in the 401(k), in the cheapest Fidelity Spartan fund offered, which is virtually identical to Vanguard’s Total Stock Market.
What Operah calls ( Aha! ) moments, I see them sometimes as ( Duh! ) moments.
Do you think taxes will be higher today, or tomorrow? Do you think that with the national debt and the bailouts in the trillions that we WILL pay for it with higher taxes in the future? I think it was Congress that estimates taxes to be 50% – 60% by mid century.
So why would anyone put their money in a 401K or an IRA? Can’t you see that the government came up with these investment vehicles to get you when you have the most money? And to make it worse, it’s the time in your life when you need money the most because it is also the time in your life when you will need more medical trips. You don’t have child deductions and I’m assuming you also worked really hard at paying off your home (the best tax deduction Uncle Sam gave us)
Roth IRAs you say? Well do the math. Have any of you done the math to figure out how much you’ll have and need in your retirement years, accounting for inflation and taxes? Do you know the rule of 72? (google it – not being rude, just don’t know how much I can type here). Back to ROTHs; do the math, whether you pay taxes now or in the future (401K, IRA) you end up with the same amount of $ (IF – taxes don’t change), if taxes go up, you are better off paying them today.
One last thing (’cause I don’t know how open you all are to these concepts). The Bush tax cuts end in 21 months. What this means is that depending on your situation, you are better off taking the hit in taxes paying to withdraw your 401K today and have your money grow tax free than keeping it and paying later (do the math, it’s simple math – if you don’t know pull a # from the air and do the math). Think about it, would you rather pay taxes on the seed? Or the harvest? Again, depends on your situation and you (age, $ amount, comfort level, etc)
Did you just have an Aha! moment? =)
I often had feeling that the 401Ks were made only to save companies funds – forget about tying up money in a retirement plan, as well as less management reporting charges – allow 401K fund charge, along with the worker pay the 401K.
One other thing about 401k loans you did not mention is you borrow pre tax dollars, you repay the loan with taxed dollars. Therefore you pay taxes on that income twice. WHY CAN’T people see through the CRAP retirement plan we allow employers to shove down our throats. Stick together people and learn about what workers have let slip away over the years. Jobs that cared about those PEOPLE who build the Wealth for the Wealthy who do not want to bring the very people making them wealth with them to a secure healthy happy comfortable standard of living. Quit working for these substandard employers that participate in these trashy retirement plans. Now I am forced to put my money into a fund in some business that I do not want to participate in. If you are going to provide a 401k it better be on top of a solid RETIREMENT PLAN.
Quit squeezing the workers.