Following up on last week’s column, here are some more mistakes commonly made with 401(k) plans:
Mistake No. 5: Investing after-tax before maximizing pretax opportunities.
Some plans allow you to choose to contribute to your 401(k) plan on a pretax or after-tax basis, or both. Many times enrollment forms give you these choices without enough explanation to guide you on which choice might be better.
As a general rule, most people will find it better to lower their W-2 earnings by contributing pretax first to take advantage of pretax savings (your W-2 will not include the earnings you deferred into your pretax 401(k)). Talk to your tax adviser for advice.
Mistake No. 6: Changing jobs and cashing out of your 401(k).
This is a big one. The IRS would love for you to take every penny out of your 401(k) when you change jobs for one very good reason: more tax revenue. And a recent survey by Edelman Financial Engines found that 28% of people between the ages of 35 and 65 who left a job where they had money in a 401(k) plan “didn’t know that some retirement distribution choices trigger tax liabilities and penalties.”
What should you do instead? Generally, you can leave the 401(k) with your old employer, move it to your new employer’s plan (if transfers are permitted) or set up a rollover IRA with a bank or financial firm such as Vanguard or Fidelity to transfer the 401(k). Don’t forget to involve your financial adviser, if you have one. The last thing you want to do is cash out of your 401(k) to buy stuff; your 401(k) is the best deal you have to secure your retirement.
Mistake No. 7: Borrowing from the plan to make consumer purchases.
84.4% of 40l (k) plans have a loan feature, according to Plan Sponsor Council of America’s 61st Annual Survey of Profit Sharing and 401(k) Plans, found at https://www.psca.org/61st_AS.
While loan provisions may be a blessing in the case of emergencies, they should not be used for consumer purchases. The rationale is set out by the body that regulates the financial services industry (FINRA). Read its report “401(k) Loans, Hardship Withdrawals and Other Important Considerations” at https://tinyurl.com/ttqbpka.
Mistake No. 8: Defaulting on a loan.
Before taking out a loan, you need to know about timing, repayment and default.
Timing: According to an IRS resource (https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules), most loans have to be repaid within five years, unless the loan is used to buy a primary residence, in which case some plans may allow as much as 25-year repayment terms. Check your plan. What happens if you can’t meet the timing?
Repayment: How do you repay the loan (usually payroll deductions), and what happens if you quit?
Default: Before you borrow, find out how a default is handled (for example, if you quit while a loan is outstanding). Usually, your 401(k) balance is used to pay the outstanding loan. When that happens, you will need to pay taxes on the withdrawal, along with a potential tax penalty.
Do your homework before taking out a loan, and include your tax adviser in the conversation.
Mistake No. 9: Deciding retirement savings can wait.
How can saving for retirement be as critical as buying a car or a new wardrobe, or going out with friends?
Who puts extra money aside for a retirement that may be years or even decades away?
People who are most successful in achieving retirement success start early and stay the course.
They follow the old adage: Pay yourself first. Consider competing consumer demands, but always understand what you are giving up by not maximizing your 401(k).
And don’t forget that there is a difference between a salary deferral and a paycheck reduction.
The 401(k) is a salary-deferral plan, not a paycheck-reduction plan.
If you do not want your paycheck reduced while contributing to your 401(k), check your withholding allowances.
It may be possible to lower the dollars you are sending to the IRS during the year in withholding taxes and redirect that money into your 401(k) contribution — without lowering your paycheck by much, if at all.
Email Julie Jason at firstname.lastname@example.org