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401(k) Pitfalls to Avoid

Jason Stipp

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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Benz: Well, it's a terrible idea. You may be able to get a hardship withdrawal under certain situations, but typically, I tell people to think about: Look at your 401(k) balance now. Think about that as about half the amount that it is now. Once you factor in taxes and penalties, that's about what you're looking at. So it's a terrible idea. I would say that this is one of my last resort ideas for someone who is in a true financial bind.

Stipp: Another option that investors may have is to get a loan from their 401(k). Is that something that should be a pitfall, or could this be useful in some circumstances?

Benz: I wouldn't put it in the category of something to be avoided at all costs. For someone who truly needs money, a 401(k) loan actually is better than going to a third party for a loan, because you pay the interest back to yourself, which is pretty attractive.

The big pitfall, though, is that if you do lose your job, you'll have to pay that money back very quickly, and you may not be in a good position to pay that money back. So there are certainly risks, but it's not nearly as bad as yanking out your money altogether.

Stipp: You need to know what you are getting into before you do it, though.

So Christine, looking a little bit more broadly, now you are saving in your 401(k), this is obviously for retirement. So the way that you're arranging the assets in that 401(k), we already talked about not just checking everything, but because it's for retirement, what should you be thinking about with your asset allocation and what pitfalls should you avoid as you're making those investment decisions?

Benz: So having that asset allocation plan is probably the key decision when it comes to how you apportion your assets, that's going to be the most decisive factor. So spend some time thinking about that. Don't just rely on what the person in the next cubicle is doing. Think about your own time horizon for the money. If you have a target-date fund in the plan, that may be an option for you, if you have no idea where to start in terms of allocating assets. There's probably some pretty well thought-out research underpinning that target-date plan. Or you could just look at, well, how is [the target-date option] apportioned for someone who is in my same age band? Maybe if I am going to pick specific funds, I can kind of mimic that, or make it slightly more aggressive or conservative.

Stipp: Use it as a guide post if you want it to be more hands-on. 

The other thing is that the 401(k) might not be the only place that you're saving money for retirement. So how should you think about all of your retirement accounts in aggregate, and what pitfalls should you avoid there?

Benz: Well, I think, it's really important, Jason. So people might have 401(k) rollover money sitting in an IRA, as well as what they are investing in the 401(k), and I think it's so important to look at all of those pools of money earmarked toward retirement as a single pool when it comes to asset allocation. I think, people sometimes think of them as separate silos, but I really like our X-Ray tool for this purpose. So all you need to do is load each of the holdings into the tool and then click X-Ray, and you can see what that asset allocation mix looks like for all of this retirement money. Is that asset allocation on track? Is it not? It's a good starting point.

Stipp: So, Christine, there are a lot of different types and flavors of 401(k) plans out there. Some are better than others. What should you think about as you're assessing the overall quality of your plan, and how would you know if it's a bad one?

Benz: Well, it's a good question, Jason. One big red flag is if you're paying a steep extra layer of fees to put the whole plan together. A lot of good plans these days have Roth options, which can be very attractive, and then you need to check up on the quality of the individual holdings and do a little bit of homework. Morningstar.com has a lot of great tools for checking up on individual options in the 401(k).

Stipp: So if I have some questions about the quality of my plan, I know that there are tax benefits, but how do I know if I am putting too much into a lousy plan?

Benz: For someone who is in a position to contribute a lot to retirement, I think, it's a mistake if the plan isn't so hot to load up on the 401(k). You might want to think about at least contributing enough to earn the match, but then going outside of the plan to an IRA, which will give you a lot more flexibility, and you won't have that extra layer of fees that come along with a 401(k).

As a side note, one other nice thing, if you invest in a Roth IRA, you can actually pull your contributions out at any time for any reasons. So it gives you a little more flexibility as well.

Stipp: And since I do want to invest at least as much as the company matches in the 401(k), if it's not that hot, is there anything I can do about it?

Benz: Well, I think one great, first step is talk to HR, talk to whoever is administering the plan. Relay what your concerns are, and if enough people speak up, I think you may be able to enact some change on that front. So I think what you tend to see is a lot of people complain among themselves, but don't ever relay what their concerns are to management, and I think that's a key step.

Stipp: So, lastly, Christine, something that you pointed out is we're familiar with a lot of the marquee fund names, Vanguards, the Fidelitys, but you may see some other names in your portfolio as well that you don't recognize. It could be a pitfall if you just cross them off the list because you don't recognize them, right?

Benz: Right. I don't think it's a disaster if you do just stick with the marquee names, but there are some really neat options that appear in some 401(k) plans. Firms that don't have a big presence in the retail marketplace, but are very good managers of say foreign stocks or small-company stocks. You may not recognize the name, but it may be a very good firm. So don't just pass those funds by; they may be actually very effective at what they do, and they may be in some cases the only way to gain exposure to a certain asset class. So it might be your only option in say small-cap stocks. So don't just write it off automatically.

Stipp: Another good time to use Morningstar.com research as well to look up some of those lesser known names. Christine, thanks so much for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.