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The Error-Proof Portfolio: 8 Mistakes That Even Sophisticated Investors Make With Their 401(k)s

Think only newbies make mistakes with their company retirement plans? Think again.

The 401(k) plan is ripe for blunders. Most people make their allocations under less-than-ideal circumstances--shortly after they've started new jobs, when they've no doubt got a lot of other pressing matters on their minds. And despite the trend toward participant education and simple solutions like target-retirement funds, 401(k) plans are still far from goof-proof. In helping a friend's daughter reallocate her company retirement plan, I noticed that this young worker was contributing equal amounts to each of her plan's options. That included a contribution to the stable-value fund--arguably not appropriate for a 22-year-old--as well as equal allocations to the plan's "Retirement 2025," "Retirement 2035," "Retirement 2045," and "Retirement 2055" options.

Yet 401(k) mistakes aren't strictly the province of newbies: Many investors with higher sophistication levels misunderstand and misuse their plans, too. What follows are some common mistakes that even more knowledgeable investors might be making. Note that these mistakes don't apply strictly to 401(k) investors but may relate to 403(b) and 457 plan investors, as well.

Mistake 1: "Winging" Beneficiary Designations
People often fill out their 401(k) beneficiary designation forms without fully considering the weight of what they're doing, especially if they're young. That makes these seemingly innocuous-looking legal documents ripe for unintended consequences. For example, an unmarried person might be inclined to designate a single sibling or parent as a beneficiary, with the assumption that the sibling or parent would in turn distribute those assets in accordance with their wishes. Yet the beneficiary might be unaware of that assumption and would certainly have no legal obligation to share those assets with anyone else. Leaving assets to minor children, as young parents might be inclined to do, is also problematic, as discussed in this interview. Even more common is failing to update these designations as life circumstances change--if you get married, divorced, or remarried, for example. People who have gone to the bother of creating an estate plan--drafting wills and creating trusts--also frequently fail to bring their beneficiary designations in line with their plans. But believe it or not, those beneficiary designations actually supersede what's laid out in your will, so it's important to work with your attorney to make sure they sync up with what's in your estate plan. This article provides some tips for beneficiary designations.

Mistake 2: Passing on Non-Name-Brand Funds
Just as seasoned shoppers might gravitate toward Prada and  Coach (COH) when discount-shopping, more knowledgeable investors might naturally veer toward the names they recognize in their 401(k) plan lineups. There's nothing inherently wrong with that; funds like  Fidelity Contrafund (FCNTX) and  Vanguard Institutional Index (VINIX) are 401(k) mainstays for good reason. But before making their allocations, investors should also take a closer look at some of the investment choices they don't immediately recognize. Some fund lineups include options run by boutiques that specialize in a given style--for example, small caps or REITs; those lesser-known managers might in fact be more nimble than the big guys. Even more common are collective investment trusts, nonmutual funds run on behalf of institutional investors like 401(k) plans. Collective trusts aren't subject to the same reporting and regulatory requirements that mutual funds are, but because they don't market themselves to the public, they might be less expensive than similar mutual fund options. This article discusses collective trusts, including more specifics on what they are and how to research them.

Mistake 3: Not Readjusting to Higher Contribution Limits
Investors in 401(k) plans who may have been maximizing their 401(k) account contributions five years ago might not be doing so now. Not only have contribution limits trended upward, but participants over 50 are able to make increased "catch-up" contributions to sock even more away as retirement draws near. The contribution limit for investors under age 50 is $17,500 for 2013, with an additional catch-up contribution of $5,500--for $23,000 total--for those over 50. Note that you can start making catch-up contributions at any time during the year in which you turn 50--you don't have to wait until your birthday. Those who are contributing to Roth 401(k)s should also bear this in mind: Because they're contributing aftertax dollars, their percentage-of-salary contribution rate will need to be higher than it was when they were contributing to a traditional 401(k) plan alone.

Mistake 4: Missing Out on Matching Dollars
Yes, not taking full advantage of an employer's matching contributions is one of those oft-cited mistakes, and you might naturally assume it applies to very novice investors. But it doesn't just happen when you forgo 401(k) contributions altogether; you can also miss out on part of your match if you're contributing the maximum allowable dollar amount to your plan. That's right--if your contribution rate is so high that you hit the maximum allowable employee contribution amount well before year-end, you'll miss out on additional matching contributions your employer would have made had you contributed throughout the year. This can be a particularly big problem if you're lucky enough to receive a large bonus in the first half of the year and part of your bonus gets paid into your 401(k) plan. The name of the game is to contribute your maximum allowable dollar amount while also maximizing your match; this article discusses the concept in greater detail.

Mistake 5: Assuming That Maxing Out Your 401(k) Plan Is Always a Worthwhile Goal
Speaking of "maxing out a 401(k)," that's often held out there as one of the most virtuous financial steps you can take. And it can be, especially for those with decent or better 401(k) plans. But it won't be a smart financial goal for everyone, especially if your 401(k) plan is truly poor (high costs are a frequent culprit) and you're not also making the maximum allowable contribution to an IRA. If that describes your situation, you'll want to contribute at least enough to the 401(k) to earn any matching funds, then turn your attention to an IRA, an investment wrapper that carries no overhead and gives you more discretion over your investment options. Only after you've fully funded the IRA should you consider contributing the maximum allowable amount to a subpar 401(k).

Mistake 6: Ignoring the Roth Option
The traditional 401(k) option--whereby you make pretax contributions in exchange for taxable withdrawals in retirement--is the path of least resistance at most companies. Not only do those contributions come out of your paycheck relatively painlessly, because you're not being taxed on them, but traditional contributions are the default option if you don't make a choice. But Roth contributions might be the better bet for you, especially if you're fairly early in your career trajectory and therefore paying tax at low rate relative to what you could end up paying in the future. Even if you have no idea how your tax rate today will compare with your future tax bracket, it's smart to consider splitting your contributions across traditional and Roth options. (Most plans with a Roth feature allow for this.) That way you're obtaining tax diversification, with some money taxed at today's rates and some to be taxed when you retire. If your company doesn't yet offer a Roth feature on its 401(k) plan, tell your benefits administrator to get with the program; the recent tax package also made it possible to convert traditional IRA balances to Roth, provided the plan has a Roth option and allows the conversion.

Mistake 7: Trading Too Frequently
Investors in tax-sheltered accounts, in contrast with taxable investors, don't get dinged on taxes on a year-to-year basis. Nor do 401(k) investors typically face commissions to buy and sell, though they may face redemption fees if they trade too frequently. That gives 401(k) investors the latitude to trade to their hearts' content with few tax or transaction costs. That can make it tempting to trade frequently, shifting out of bonds and into stocks, putting more money into the funds that have recently been tearing it up, and so forth. But just because that kind of trading doesn't carry readily quantifiable costs doesn't mean you won't hinder your returns. Instead, by turning your portfolio over frequently, you increase your susceptibility to timing-related missteps--arriving at a hot fund or asset class just as it's cooling off. Morningstar's Investor Returns statistics aim to quantify the extent to which investors shortchange themselves with mistimed trading, and those costs can be substantial.

Mistake 8: Not Complaining About a Lousy Plan
Last but not least, one of the most frequent 401(k) mistakes participants make is to take a lousy plan lying down. Rather than grumbling about your plan with coworkers, document your plan's drawbacks in writing, ask other like-minded colleagues to do the same, and share that information with the benefits decision-makers at your firm. At smaller firms, in particular, 401(k) plans might be overseen by people who don't have a deep background in investing matters, so they may welcome your feedback.

See More Articles by Christine Benz

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