Costly 401(k) Mistakes to Avoid
A 401(k) plan is an employer-sponsored retirement savings plan. It allows employees to save and invest a part of their salary before taxes are taken. The taxes on a 401(k) account are not paid until the money is withdrawn. This type of retirement account gives you control over how you decide to invest your money.
Typically, 401(k) plans give you the opportunity of spreading mutual funds consisting of bonds, stocks and market investments. The 401(k) retirement plan is named after the tax code section that governs it. This retirement plan started in the 1980s as a way of supplementing pensions. Most employers in the United States now offer the 401(k) plan.
There are several ways to make the most of your 401(k) account. There are also many mistakes you could unwittingly make that would cost you dearly. The following guide discusses the costly mistakes that can happen and how you can avoid them.
Not Contributing Enough to Your 401(k) Account
If you want to end up with a healthy amount of money by the time you reach retirement age, you need to contribute as much as you can to your 401(k) account. Are you counting on the funds in your 401(k) account to be your major source of income during your retirement? If so, the most costly mistake you can make is to not contribute enough.
How much should you contribute? First of all, companies usually match funds, so make sure you always contribute as much as you need to in order to take advantage of this contribution matching. Secondly, pay the proportion of your income recommended by financial advisors, which is roughly 10 percent of your salary. If you get a pay rise, make sure you continue to contribute 10 percent of your income.
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Whenever you have the opportunity of paying more into your 401(k) account, do so. The limit for the contributions you can pay into your 401(k) account is currently $18,500 annually. Your goal is to contribute this amount yearly, although this often means having to pay more than the 10 percent of your income recommendation.
Paying Excessive Fees
Do you know how much the fees are for your 401(k) plan? Believe it or not, 60 percent of people do not even know they are paying any fees at all. Although some 401(k) plans offer low costs for employees, other plans have excessive fees and expensive funds. If you do not bother to look at the fees you are paying and how you can avoid paying such excessive costs, you are making a big mistake.
If you are paying high fees, you can obtain lower-cost funds by moving your money. It is a requirement of the 401(k) plan to send you an annual fee disclosure statement. This lists how much every fund in the plan costs to own.
If this statement is not sent to you, you can obtain it from the service provider of the plan or your human resources department. Once you have acquired a copy, check it carefully to see if lower-cost funds are available in your 401(k) plan. Do not overlook how much fees can add up either. A three percent fee may not sound like a lot, but over decades, the amount can significantly add up.
Setting Yourself Up for Disqualification
If you do something with your 401(k) account that makes you a disqualified person, you are prohibited from doing business with your retirement plan. Avoid costly mistakes that could disqualify you. The main rule is to do not lend to yourself or invest in yourself through your 401(k) plan. You cannot be both the trustee and the beneficiary of your retirement plan.
The same goes for relations like cousins and uncles and any lineal descendant or ancestor of the trustee. You become disqualified for these practices because they allow you to use your account’s assets without paying tax on them.
There are many transactions prohibited in relation to the above. For example, through the funds of your 401(k) account, you are not allowed to:
- Purchase life insurance.
- Purchase tangible personal property, such as alcohol.
- Purchase collectibles, such as artworks and jewelry.
- Lend money to someone who is disqualified.
- Lease, sell or exchange property between the 401(k) retirement plan and a qualified person.
You can withdraw money from your 401(k) plan before you reach retirement age, but this can be a costly mistake. Leakages from your account over time mount up, significantly making a difference to how much you end up with by retirement. When you cash-out your account, you not only have to pay state and federal taxes, you are also charged a penalty for the withdrawal. Cashing-out penalties and taxes typically make up a third of your account’s value so early withdrawals must be avoided.
In certain approved situations, a hardship distribution can be withdrawn from a 401(k) account. This happens when you can prove you are in dire need of money. You have to pay tax on the withdrawal, as well as a withdrawal penalty.
A hardship distribution withdrawal can permanently make your account balance low, so avoid it. In addition, you are not allowed to make contributions to your 401(k) plan for a period of six months after a hardship distribution withdrawal.
Not Consolidating Plans
If you change jobs, you may end up with two 401(k) plans. If you change jobs frequently, you may acquire more than two. It is fine to maintain your 401(k) plan with your former employer. Sometimes this can be beneficial if the plan has great investment opportunities such as company stock and low fees.
However, several 401(k) plans can become problematic and you may end up losing money through paying different taxes. It is, therefore, best to consolidate your plans. The best way is to open an IRA. You can then pay your 401(k) balance into the IRA every time you switch jobs. This helps to maintain tax benefits and it also gives you a broader range of investment opportunities.
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