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…When used properly, an employer-sponsored 401(k) can be a
powerful tool to save for your retirement years, but there are a couple of crucial pitfalls that you have to watch out for…Here is a list of potential downsides to 401(k) plans — and how to work around them.
The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article by Damian Davila(WiseBread.com)
1. Waiting to set up your 401(k)
Depending on the applicable rules from your employer-sponsored 401(k), you may be eligible to enroll in the plan within one to 12 months from your start date. If your eligibility kicks in around December, you may think that it’s fine to wait until the next year to set up your retirement account.
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This is a big mistake for two main reasons:
- Contributing to your 401(k) with pretax dollars allows you to effectively reduce your taxable income for the current year. In 2017, you can contribute up to $18,000 ($24,000 if age 50 or over) to your 401(k), so you can considerably reduce your tax liability. For example, if you were to contribute $3,000 between your last two paychecks in December, you would reduce your taxable income by $3,000. Waiting until next year to start your 401(k) contribution would mean missing out on a lower taxable income!
- Your employer can still contribute to your 401(k) next year and make that contribution count for the current year, as long as your plan was set up by December 31 of the current year. Your employer contributions have to be in before Tax Day or the date that you file your federal taxes, whichever is earlier.
How to work around it
If you meet the requirements to participate in your employer-sponsored 401(k) toward the end of the year, make sure to set up your account by December 31st. That way, you’ll be ready to reduce your taxable income for the current year through your own contributions and those from your employer before their applicable deadline (December 31 and Tax Day or date of tax filing (whichever is earlier), respectively).
2. Forgetting to update contributions
When you set up your 401(k), you have to choose a percentage that will be deducted from every paycheck and put into your plan. It’s not uncommon that plan holders set that contribution percentage and forget it. As your life situation changes, such as when you get a major salary boost, marry, or have your first child, you’ll find that your contributions may be too big or too small.
How to work around it
To keep a contribution level that is appropriate to your unique financial situation, revisit your percentage contribution every year and whenever you have a major life change. Don’t forget to also check whether or not you elected an annual increase option — a percentage by which your contribution is increased automatically each year — and adjust it as necessary.
3. Missing out on maximum employer match
Talking about contributions, don’t forget that your employer may contribute to your plan as well. In a survey of 360 employers, 42% matched employee contributions dollar-for-dollar, and 56% of them only required employees to contribute at least 6% from paychecks to receive a maximum employer match.
How to work around it
Employers require you to work a minimum period of time before starting to match your contribution. Once you’re eligible, meet the necessary contribution to maximize your employer match. One estimate puts the average missed employer contribution at $1,336 per year. This is free money that you can use to make up for lower contribution levels from previous months or years.
4. Sticking only with actively managed funds
When choosing from available funds in their 401(k) plan, account holders tend to focus on returns. There was a time in which actively managed funds were able to deliver on their promise of beating the market and delivering higher-than-average returns. That’s why 401(k) savers often choose them.
However, passively managed index funds — funds tracing an investment index, such as the S&P 500 or the Russell 2000 — have consistently proven that they can beat actively managed funds. Over the five past years, only 39% of active fund managers were able to beat their benchmarks, which is often an index. That’s why over the same period, investors have taken $5.6 billion out of active funds and dumped $1.7 trillion into passive funds.
How to work around it
Find out whether or not your 401(k) offers you access to index funds. Over a long investment period, empirical evidence has shown that index funds outperform actively managed funds. Review available index funds and choose the ones that meet your retirement strategy.