Are you making a mistake in your 401(k) that you are not aware of? Not everyone has access to a 401(k) plan, but if you do, it is a fantastic opportunity to save for retirement. Choosing a 401(k) plan is a step in the right direction, but if you don’t pay attention, you may make mistakes that you aren’t even aware of. These mistakes can be costly, but with the right planning, you can avoid them. Below are the three most common 401(k) mistakes that I often see plus one bonus mistake many people also make.
1. Leaving your 401(k) up to chance
There are two questions to ask yourself when contributing to a 401(k). These questions are: How much am I contributing and how is my 401(k) contribution invested? Did you make those two choices deliberately or did you just let your employer choose the default options for you?
Often, there is a default amount, usually a percentage of your pay, that will be taken from your paycheck and sent to your 401(k). This amount is generally the minimum amount to receive the employer match and is probably not as much as you should be contributing to your retirement savings.
Once your 401(k) contribution comes out of your paycheck, it gets sent to the financial institution that holds your 401(k) plan. There is usually a default investment fund if you do not choose one for yourself. This fund is often a target-date fund. This may be an ok choice, but is not necessarily the optimal choice for everyone. Often these target-date funds have higher fees than other investment funds. Also, they match the investment allocations in that fund to your age and don’t take into account your personal risk tolerance or when you actually want to retire. Some plans don’t invest the money in the market at all, leaving your money sitting in a money market account earning almost nothing.
It is important to be intentional in the decisions you make with your 401(k), both with how much you should save and with where your money is invested. This is your hard-earned money and it is there to allow you to live freely in retirement.
2. Focusing on past performance of your 401(k)
I was having lunch with one of my former coworkers while I was working at a nonprofit that I used to work at in Washington, D.C. She was sharing how she just signed up for her 401(k). I asked her, “Okay, that’s great. How did you choose where your 401(k) contributions are going to be invested?” She said, “Oh, it’s really easy. I sat down and looked at all the 401(k) fund options and I just chose the funds that performed really well in the past five to ten years.” It was pretty intuitive for her to do that because she wants to pick winners. We all want to pick winners.
The problem with this is that sometimes in life, that method doesn’t really apply. For example, in basketball, I used to follow the NBA a lot. In 2017/2018, the Golden State Warriors dominated the league. They were NBA champions. Going into 2019, a lot of people still thought they were going to do a three-peat. They were up against the Toronto Raptors. The Golden State Warriors lost and the Raptors won.
It is the same with investing. When you look at the past performance of these 401(k) funds, it’s almost like driving while looking at the rearview mirror. When you’re driving, you always want to look forward. In investing, sometimes it’s actually cyclical and you might be misled by past performance data. Don’t focus too much on past performance because often, it doesn’t really tell you anything at all.
3. Diversifying your 401(k) across many funds
We all know that diversification is important. We don’t want to put all of our eggs in one basket. However, if you diversify across too many funds, diversification can work against you. Let me tell you another story about another former coworker of mine in the same nonprofit. She was also signing up for a 401(k) and she said, “Hey, Alvin, can you take a look at this for a second? I’m about to submit my 401(k) allocation.” She had chosen around 15 different funds and put equal amounts of money in each as a way to have a diversified fund.
If you do that, you are likely going to select funds that are good and you’re also going to end up selecting funds that are not as good because you’re just randomly picking. More importantly, your percentage of stocks and bonds is going to be completely random because you chose random funds. You shouldn’t randomly pick stocks in the name of diversification. This is where the value of a financial planner comes in. A financial planner can guide you in terms of how you select the 401(k) funds and how much you can or should contribute to your 401(k).
Bonus 401(k) Mistake: Ignoring the Roth 401(k) option
Those are the three biggest 401(k) mistakes I often see people make. But there is one more mistake I see many people making with their 401(k) plans. This does not apply to everyone, because not everyone has this option. But another big mistake that you might be making in your 401(k) is ignoring the Roth 401(k) option. When you are selecting how much to contribute to your 401(k), for the most part, you have the option to contribute in a pre-tax manner. This means that however much you contribute to your 401(k) will be deducted from your taxes.
The other option some 401(k) plans have is allowing you to contribute to a Roth 401(k). Why would you want to contribute to a Roth 401(k)? Well, if you contribute to a Roth 401(k), you don’t get a tax deduction on your contributions now, but your money is going to be tax-free when you retire. So let’s say over the course of the next five years, you put in $80,000 and you double, triple or quadruple that in the market over time. You’re not going to pay taxes on the money that you make if you put that money in a Roth 401(k).
Now, this is not for everyone. You need to examine whether your tax bracket now, is it gonna be lower or higher compared to your tax bracket when you retire? That will most likely determine whether or not it’s best for you to contribute to a pre-tax 401(k) or to a Roth 401(k).
I have shared with you the biggest and most common 401(k) mistakes that I often see. Saving for retirement is important. A 401(k) can be an easy and convenient option because the contributions are automatically deducted from your paycheck. As financial planners, we will help you avoid these mistakes and help you achieve your financial goals. Lastly, if you have an old 401(k), you recently moved jobs, or it’s been a while since you moved jobs but you have a 401(k) with your old employer, you may be thinking of rolling it over to an IRA. Before you do, make sure you check out my video on three reasons not to move it to a rollover IRA.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help middle-class professionals achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.