Don't Make A 401(k) Mistake - 10 Tips replacing Tax Savings Tips

Hewitt Associates has outlined their top 10 tips for employees to make the most of their 401(k) plans.

"For many employees, a 401(k) plan is their only source of retirement income so it's critical that this benefit is used to its full potential," says Lori Lucas, defined contribution consultant, Hewitt Associates. "It's disheartening to see employees make mistakes that could cost a lot in the long run, especially when it's time to retire."

Hewitt offers the following tips:

  1. Join the club. Participate in the plan.

    According to Hewitt's research, the majority of companies offer a 401(k) plan . Yet, participation rates average at about 77 percent . Hewitt's research shows that employees nearing retirement (age 50 - 59) had the highest participation (86 percent), while those furthest from retirement (age 20 - 29) had the lowest participation (59 percent). Join the plan and enjoy the tax benefits. Not only can contributions lower your tax income, but the money grows tax-free until you withdraw it at retirement.

  2. Don't leave money on the table. Take advantage of your company's match.

    Ninety-seven percent of employers provide some form of match or contribution to employees' 401(k) plans . In a Hewitt study of nearly 150,000 employees, more than half (59 percent) of employees eligible to receive an employer match did not contribute up to the maximum match threshold. Of those 401(k) participants failing to take advantage of the company match in the first year, 81 percent failed to take advantage of the match in the second year as well.

    "When employees do not take advantage of the company match -- especially when it is immediately vested -- participants are leaving free money on the table," said Lucas.

  3. Compounding is a good thing. Understand and appreciate its power.

    Examining nearly 500,000 eligible employees with salaries under $80,000, Hewitt found that nearly half (46 percent) of employees age 20 - 29 contributed zero. With a median account balance of $3,600, these participants could fall far short of their retirement goals if they failed to contribute additional money during their 20's.

    Take for example, an employee with a 401(k) balance of $3,600 at age 25 who fails to contribute until age 30 and after that contributes $5,000 per year. Assuming a 10 percent annual rate of return, that employee would be giving up $260,000 at retirement (age 60) versus if that same employee had contributed as little at $2,400 per year from age 25 to age 29 ($12,000 total).

    "While employees tend to contribute more to the plan as their salaries increase and they get closer to retirement, it's clear that young 401(k) investors especially do not realize what they are giving up when it comes to the power of compounding," said Lucas.

  4. Set your savings goal and don't be arbitrary when choosing your contribution rate.

    Hewitt's research indicates that 401(k) participants are drawn to round numbers such as 5 or 10 percent when choosing contribution rates. In the group of 500,000 eligible employees, Hewitt found that nearly one quarter (23 percent) chose these contribution levels.

    "Employees need to consider their needs and personal circumstances when choosing their contribution rate," said Lucas. "The fact that contribution levels tend to anchor at these random numbers suggests that employees are not necessarily matching their personal savings requirements with their choice of contribution level."

  5. New job? Don't cash out your 401(k).

    Hewitt's analysis of nearly 170,000 defined contribution plan distributions shows that 68 percent of 401(k) plan participants opt for lump sum cash payments when changing jobs . Less than one-third (26 percent) roll their balances into IRAs and only 6 percent move their money to their new employers' plans.

    No matter how small the balance is, it is important to keep the money tax-deferred. Not only will employees cashing out lose out due to tax implications, but they will not reap the benefits of potential savings over time.

  6. Lifestyle funds can be helpful -- if you use them appropriately.

    Although employers offering lifestyle funds intend them to serve as turnkey investment solutions, where 401(k) participants simply match up their time horizon and risk preferences with a single fund, Hewitt's research shows that few 401(k) participants use them this way. Instead, participants mix lifestyle funds with other funds, resulting in homogeneous portfolios, regardless of age and years left until retirement.

    "Participants need to realize that lifestyle funds are not 'just another fund option,' said Lucas. "If you choose to use a lifestyle fund, match the fund with your time horizon and stick to it. Otherwise, you might defeat its purpose and weaken its effectiveness."

  7. On autopilot? Don't let inertia drive your investments.

    Automatic enrollment -- the practice of automatically signing up employees to participate in a company's 401(k) plan unless they specifically choose not to -- is a successful method to increase participation rates. However, according to Hewitt's research , automatically enrolled participants tend to remain at conservative default elections, even after one year of participation in the plan.

    Employees should remember that default elections are a starting point and it's their job to adjust contribution levels and fund selections based on how much they need to save and how much risk they should assume.

  8. It's okay to take a loan. It's important to understand its impact.

    Increasingly, employers offer loan provisions in 401(k) plans. In fact, loan provisions in plans have grown from 67 percent in 1991 to 92 percent.

    Hewitt's study of nearly 400,000 plan participants shows that nearly 30 percent of participants had loans outstanding; with an average principal outstanding amount per participant of $6,900 (on average balances of $57,000). The research also shows that nearly 30 percent of 40 - 49 year-olds -- the highest percentage of all age groups -- had loans outstanding.

    "Borrowing against your 401(k) savings can be a relatively easy and inexpensive way to raise needed money," said Lucas. "However, 401(k) loans are not a no-brainer. They're typically due immediately when you leave the company, something to consider in shaky economic times."

    It's important to remember that when you borrow from your plan, your account is reduced by the amount of your loan. While the money isn't lost since you will pay it back with interest, you do lose out on whatever additional return the money might have earned had you left it in the account.

  9. Diversify. Take advantage of the funds at your disposal.

    Hewitt's research shows that that average 401(k) plan offers 11 investment options. Yet, Hewitt's study of 500,000 plan participants finds that 36 percent of participants allocate contributions to a single fund. Another 19 percent allocate contributions to only two funds.

    "By failing to take advantage of the funds available within a plan, participants may be cheating themselves out of diversification opportunities," said Lucas. "They may be assuming more risk than they need to for the level of return that they are likely to realize."

  10. Don't forget to rebalance.

    Further evidence that 401(k) plan participants tend to buy and hold is Hewitt's study of nearly 500,000 401(k) participants, which found that 28 participants made a trade. Older participants with higher salaries and longer service histories were more likely to make a trade than younger participants.

    "While it's commendable that participants are picking and sticking when it comes to their long-term retirement assets, if participants do not interact with their plan in a given year, it could be that they are allowing their asset allocation to get out of balance," said Lucas. "Over time, it's possible that because funds grow at different rates, a moderate portfolio could become more aggressive, leading to unexpected vulnerability when the market gets rough."

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