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By Jason Stipp | 03-14-2011 12:32 PM

401(k) Pitfalls to Avoid

Morningstar's Christine Benz helps investors avoid common mistakes with contributions, cash-outs, allocation, and more.

Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax Relief Week on Morningstar.com, and today we're talking about your tax-sheltered accounts, specifically your 401(k) plan. There are a lot of benefits to the 401(k), but there are also some potential pitfalls.

Here with me to talk about avoiding those pitfalls is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So these are good accounts. A lot of people have access to them through their work, but there are some important things to keep in mind. I'd like to start with what may seem like the obvious ones, but to a newcomer to 401(k)s, nonetheless very important ones to consider. The first one has to do with the company match. How should investors think about the company match and maximizing that?

Benz: Right. So this is an easy one, really, Jason. If your company is giving you any matching funds on your contributions, the bare minimum you should do is invest enough to earn that match because that's a 100% return right out of the box on your money; forgoing that is really a terrible investment decision.

Stipp: And one of the things that we've seen some data on is about where people are invested within their plans and plans usually have a range of options, from very conservative to very aggressive. What are some of the mistakes that we've noticed just top line?

Benz: Well, on the one end of the spectrum would be people who stay way too conservative. So we've seen a lot of data pointing to people holding far too much in cash or in the stable value option within the plan. Sometimes that's the default option, so if you do nothing, and the company is opting you in, you may end up there, but still if you have a long time horizon, that's obviously a bad place to be, especially right now given what cash is earning. So you don't want to be too conservative.

Another big pitfall in terms of allocation is holding too much in the company's stock, and this is way at the other end of the spectrum on risk, in that you have so much of your economic wellbeing staked with your company in terms of your job and your paycheck--by holding too much in the company stock, you're really levering up and you're altogether too beholden to what happens to your company. And we've obviously seen some terrible marquee name companies go down in smoke, and we've seen some employees have their 401(k) plans brought down right along with them.

Stipp: So really, in effect, you'd be doubling down if you had a lot of that 401(k) in that company stock.

Another thing I think that for a lot of newcomers, they are presented with the 401(k) plan when they start a new job. It has this list of options, this menu of options, and one of the instincts is well, maybe I should be a little bit in each one of those. What's wrong with looking at it that way?

Benz: Right, you know there is nothing wrong with diversifications, so the sentiment behind that idea, even if it maybe isn't that well thought out, is not terrible. But you can really do some weird things to yourself. So I've seen actually instances where someone checked I want to be in the Target 2020, I want to be in the Target 2030, you know, and really ended up with odd ball mixes of assets, and to me that's a big red flag that the person isn't spending even a small amount of research to investigate those individual choices.

Stipp: It could be a lot of overlap on those choices, for one thing… but also there could be some instances, if you were just equally-weighting across the options, that you'd end up with more than you really would need for your portfolio.

Benz: Right, you could end up with a lot in emerging-markets stock and small-cap stock versus some of those core holdings that you want.

Stipp: So definitely, don't just go down the line and check those off.

Another thing, Christine, I think that is tempting to a lot of folks is they'll have a little bit saved up in their 401(k), and then they'll have some financial difficulties. Cashing out seems like it's a bad thing to do. How bad is it? How much should you avoid cashing out that 401(k)?

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