While company retirement plans
often have guardrails, investors can goof with contributions, investment
selections, loans, and withdrawals.
A company retirement
plan--whether a 401(k), 403(b), or 457 plan--is the starter savings vehicle for
many investors, so it's probably not surprising that the plans usually have
more guardrails than other investment vehicles.
Company retirement plan menus
typically feature plain-vanilla stock and bond funds to keep plan participants
from gorging on exotic investment choices, and participants are often opted
into age-appropriate target-date fund vehicles. And because 401(k) participants
are often extremely hands-off, many plans offer features such as automatic
escalation to increase contributions as participants' salaries grow.
Yet not all plans include such
safety features, and 401(k) menus aren't universally high quality. Plans
offered by small employers may be larded with extra administrative fees or
high-cost funds, and their lineups may skimp on core asset classes such as
international equity or fixed income. Participants can also run into unforced
errors--for example, not paying enough attention to asset allocation when
making their investment selections, or cashing out their money when they change
jobs.
In short, 401(k) plans invite the
potential for plenty of goofs. Here are 20 common ones, as well as tips on
avoiding those mistakes. (Note that in the interest of brevity, "401(k)"
will be used as a shorthand for all company retirement plans throughout this
article, but the points generally apply to 403(b)s and 457 plans as
well.)
1. Not Considering Asset
Allocation Before Making Investment Choices
When making investment
selections, 401(k) participants are typically confronted with a menu of
individual fund choices. The importance of setting an age- and
situation-appropriate stock/bond mix never even comes up, even though that will
be the biggest determinant of how the portfolio behaves. Setting an appropriate
asset-allocation mix is more art than science, but target-date funds can be a
good starting point.
2. Not Investing Differently If
Your Situation Is an Outlier
Target-date funds are often the
default options in 401(k) plans, and they're valuable in that they can help
investors set their asset allocations and monitor them on an ongoing basis.
Even investors who don't intend to invest in a target-date fund can use them to
help determine an age-appropriate investment mix. That said, the allocations
embedded in target-date funds won't be right for everyone, especially for
people with substantial "assets" outside their 401(k) plans. For
example, individuals who will be able to rely on pensions to cover most of
their in-retirement expenses will likely want a more aggressive asset
allocation than would be the case for generic target-date funds. (For this
reason, some employers use custom target-date funds, tailored to the situations
of their plan participants.)
3. Not Factoring in Other
Assets When Making Investment Selections
For investors who have been
working and investing for a while--or those with spouses who hold their own
investment accounts--their 401(k) plans may be but a small piece of their
overall assets. In that case, it's wise to factor in all of the retirement assets
when determining how to allocate the 401(k).
4. Focusing Too Much on Past
Returns When Making Investment Choices
In addition to not getting much
coaching on their asset allocations, many 401(k) participants are given a
limited amount of information about the investment choices on their plans'
menus. They may see a fund's asset class or category, as well as its returns
over a certain time period, such as the past five years. Is it any wonder so
many novice investors simply reach for the funds with the highest numbers? Of
course, that's not a recipe for great investment results, as those high
performers often revert to the mean. Rather than chasing the hottest
performers, investors are better off focusing on fundamental information about
funds' strategies, management, and expenses to help populate their
asset-allocation mixes.
5. Venturing Into the
Brokerage Window Without Paying Attention to Transaction Costs
If investors do their homework on
the fund options on their 401(k) menu and find them wanting, the ability to
invest via a brokerage window might appear to be a godsend. Such windows
typically give participants many more choices than they have on the preset
menu, including the ability to invest in individual stocks and exchange-traded
funds. The big downside, however, is that participants will typically incur
transaction costs to buy and sell securities within the brokerage window. Those
trading costs can drag on returns, especially for investors who are making
frequent small purchases.
6. Avoiding No-Name Funds
Company retirement plan menus are
often populated with funds from the big shops--Vanguard, Fidelity, T. Rowe
Price, and American Funds. But plans may also include less-familiar names,
often collective investment trusts that are explicitly managed for retirement
plans. Although information may be less widely available on some of these
options than is the case for conventional mutual funds, their expenses may be
low and their quality may be good.
7. Overdosing on Company Stock
In 2014, the average 401(k) plan
participant has more than 7% of his portfolio in stock of his employer,
according to information from the Investment Company Institute. That's not
a scary number in and of itself, but many participants obviously have much
higher stakes and some have none. Even if an employer doesn't run into
Enron-style problems, employees with a lot of company stock have too much of
their economic wherewithal riding on their employer's performance: their own
jobs, plus their portfolio's performance as well. As Morningstar's David
Blanchett says, most investors are better off limiting their positions in
company stock, though there may be a few mitigating situations in which to hang
on to it.
8. Not Taking Full Advantage
of the Tax-Advantaged Wrapper
One of the big advantages of a
401(k) plan is tax-deferred compounding: Even if an investment is kicking off
heavy income or capital gains distributions, the 401(k) investor won't owe any
taxes until he or she begins pulling money from the plan. For that reason, it's
wise to stash those investments with heavy year-to-year tax costs inside a
401(k) or IRA. That includes funds that invest in high-yield bonds and Treasury
Inflation-Protected Securities, REITs, and high-turnover equity funds. That
said, investors needn't go out of their way to add high-tax-cost investments if
they don't make sense for them from an investment standpoint. Most young
investors have little need for bonds within their 401(k) plans, for
example.
9. Trading Too Frequently
The tax-deferred nature of a
401(k)--combined with the fact that 401(k) investors don't typically incur
sales charges to buy and sell shares of funds on the plan's preset menu--can be
an invitation to trade frequently or to employ tactical, market-timing
strategies. But Morningstar Investor Returns research findings cast doubt
on whether investors can add value with frequent trading; investors in
multiasset vehicles like target-date funds and balanced funds, because they
often buy and then sit tight, tend to garner better outcomes than investors
venturing into and out of individual categories.
10. Sticking With Default
Contribution Rate
In the interest of encouraging
more employees to participate, many employers are now automatically enrolling
their employees in the 401(k); employees need to actively opt out if they don't
want to take part. The early results of these efforts show that many employees
who are automatically enrolled do, in fact, stick with the plan--a positive
outcome. However, employees who stick with the default contribution rate after
they've been automatically enrolled--the average is 3.4%--may not earn their
full employer matching contribution, if it's a generous one. Moreover, a 3.4%
savings rate--assuming the employee isn't also saving outside the 401(k) plan
and/or doesn't have a very high salary--is far below any reasonable
retirement-savings target.
11. Not Taking Advantage of
Other Automatic Features
In recognition of the fact that
initial default contribution rates may be insufficient, some plans also opt
their employees into "auto-escalation"--nudging up their
contributions as the years go by. For other plans, automatic escalation is
voluntary. Taking advantage of this option can be a painless way for employees
to save more of their salaries, particularly if their contributions increase at
the same time they receive raises. Automatic rebalancing can also help
hands-off investors by regularly restoring their portfolios back to their
target-allocation mixes; while investors themselves may not be inclined to trim
their winners or add to stocks when they're in the dumps, as rebalancing
requires them to do, automatic rebalancing helps ensure disciplined portfolio
maintenance.
12. Not Keeping Up With
Increased Contribution Limits
Company retirement plan
participants who have been maxing out their contributions for many years may
forget that the definition of "maxing out" is a moving target. The
maximum allowable contribution for savers younger than 50 was $10,500 back in
2000, but today it's up to $18,000. In addition, investors older than 50 can
begin making additional catch-up contributions on Jan. 1 of the year in which
they turn 50; for 2017, investors older than 50 can contribute a full $24,000
to their 401(k)s.
13. Maxing Out a Lousy Plan
Maxing out a 401(k) plan isn't
always a worthy goal, however. If an investor's 401(k) plan features high costs
and/or subpar investment options, he or she is usually better off investing
just enough in the 401(k) plan to earn any employer matching contributions,
then investing any additional retirement assets in an IRA. Investing inside an
IRA doesn't typically entail additional administrative expenses, and investors
can also populate their IRAs with low-cost, high-quality investment options. The
investor with a lousy 401(k) may then choose to invest any additional monies
inside the 401(k), but IRA contributions should come first.
14. Ignoring the Roth Option
Many investors came of age when a
traditional 401(k) plan--pretax contributions going in, taxable distributions
on the way out--was the only game in town. Today, however, more and more 401(k)
plans are allowing participants to make Roth 401(k) contributions instead
of--or in addition to--traditional contributions. Roth contributions consist of
aftertax money, but there are no taxes as the money compounds in the account or
when it is withdrawn during retirement. Because young investors are often
paying taxes at a lower rate than they are apt to be when they retire, Roth
contributions can make a lot of sense for early accumulators. And for investors
who have been accumulating traditional 401(k) assets for many years, directing
new contributions to the Roth option can provide them with tax diversification
that's valuable in retirement.
15. Not Paying Enough
Attention to Beneficiary Designations
Many investors don't put a lot of
thought into their beneficiary designations. Young investors may choose a
parent or sibling as the beneficiary of their account, for example, and then
fail to update their beneficiaries after they've married or drafted other
estate-planning documents.
16. Letting Orphan 401(k)s
Pile Up
We're a nation of job-changers,
so it's probably not surprising that many people have multiple small 401(k)s
left over from previous employers. The downside is that very small 401(k)
accounts may be sent packing. And even investors who have larger sums at work
in former employer's plans may suffer from portfolio sprawl. Holding many small
accounts can make it difficult to assess the total portfolio's asset allocation
and can also present an oversight challenge.
17. Assuming a Rollover to an
IRA Is Always the Best Course
While rolling 401(k) assets into
an IRA can lower overall costs and provide entry to a broad range of investment
options, it's not the right option in every situation. If you highly value the
investment options inside the plan or benefit from its creditor protections,
you may have good reason to stay put inside the confines of a 401(k).
18. Borrowing Against It
Going purely by the numbers,
taking a loan from a 401(k) trumps other types of financing, such as credit
cards or even a home equity line of credit. That's because the 401(k) borrower
has to pay interest on the loan back into the account, not to a bank, helping
to offset the opportunity cost of not having that money invested. Yet, 401(k)
loans carry a big drawback, in that in the event of job loss, the money must be
paid back within a fairly short window of time.
19. Taking Out the Money When
You Change Jobs
For investors who are between
jobs, raiding a 401(k) may beckon as a tantalizing way to free up a good chunk
of change to cover living expenses or pay off debt. But the costs of doing so
are high: In addition to ordinary income tax, early nonqualified withdrawals
are subject to an additional 10% penalty. Thus, prematurely raiding a 401(k)
should only be considered as a last resort, well behind options like pulling
from a Roth IRA, which allows for tax- and penalty-free withdrawals of
contributions.
20. Not Rolling a Roth 401(k)
Into a Roth IRA to Avoid RMDs
In contrast with Roth IRAs, which
aren't subject to required minimum distributions, Roth 401(k)s are subject to
RMDs post-age 70 1/2. While there may be a few instances when it makes sense to
stay put in a Roth 401(k) and put up with the RMDs, in most cases a rollover to
a Roth IRA--before RMDs from the Roth 401(k) commence--is the better course of
action. Not only can the money in the Roth IRA continue to grow on a tax-free
basis, but the investor can consolidate the 401(k) assets into a single account
for easier oversight in retirement.
Click here
for the original article from Morningstar.