401(k) Investors: Avoid These 20 Mistakes
While company retirement plans often have guardrails, investors can goof with contributions, investment selections, loans, and withdrawals.
Note: This article is part of Morningstar's February 2016 Tax Relief Week special report. A version of this article appeared on Feb. 24, 2015.
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, I'll use "401(k)" 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 or benchmarks like Morningstar's Lifetime Allocation Indexes can be a good starting point. This article provides some pointers on arriving at a sensible for your retirement portfolio.
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.) This article discusses how to know if you're an asset-allocation outlier.
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). Morningstar's X-Ray function can help investors see the composition of their total portfolios across accounts; they can then use their 401(k) plan assets to help steer the total portfolio toward their desired asset-allocation mix.
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. Morningstar's qualitative Analyst Ratings attempt to pull all of these considerations together into a single forward-looking measure.
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. This article provides some pointers for researching collective trusts and other non-name-brand options that might appear inside your 401(k).
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 discusses in this video, 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 data casts doubt on whether investors can add value with frequent trading; investors in target-date funds, because they often buy and then sit tight, often 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 under 50 was $10,500 back in 2000, but today it's up to $18,000. In addition, investors over age 50 can begin making additional catch-up contributions on Jan. 1 of the year in which they turn 50; for 2016, investors over 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. This article provides guidance on setting beneficiary designations and keeping them up to date.
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. This article provides pointers on what to do with very small orphan 401(k)s, and this article discusses the logistics of 401(k) rollovers.
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). This article discusses these and other such circumstances.
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. This article discusses the pros and cons of 401(k) loans.
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. (Note that President Obama's budget proposal, released in mid-February 2016, included a provision to make Roth IRAs subject to RMDs, but for now they are not. This article discusses the retirement-related provisions of President Obama's budget proposal.)