I’m Robert from The College Investor and I’m swapping blogs with Kevin today for the Yakezie Blog Swap! You can head over to my site to read Kevin’s pet peeve about Roth IRAs.

My biggest financial pet peeve has to do with 401(k)s and how the government tries to make it easy to save, but then gives people every way possible not to save. I hear all kinds of things at my day job: “I don’t know if I should start my 401(k)” or “Maybe I will just take a 401(k) loan to pay off my credit card debt”, or the very worst “I will just withdraw from my 401(k) to buy this unnecessary material object”.

Just hearing all of these things makes me cringe, and I do my best to educate, but should it really be up to the few people here and there to prevent others from making huge financial mistakes? I don’t think so, and here are some easy fixes, if anyone will listen:

Mandatory Enrollment

My first issue with 401(k)s is that most of them come with a matching contribution from the employer, yet so many employees are leaving this free money on the table. My employer matches dollar-for-dollar, up to 5% of my pay. Just by enrolling in my 401(k) and contributing 5% of my pay, I get an instant 5% raise. Who doesn’t want free money!?!? If your employer offers a match, it is a huge mistake to not get all of the free money you are eligible for. According to a survey by Hewitt Associates, 22% of 401(k) participants eligible for a company match don’t contribute enough to get the maximum amount.

A simple solution for all parties involved is mandatory enrollment with an option to opt-out. So, if you get a new job, you are automatically enrolled into the 401(k), if offered. In a study by Vanguard, it was found that opt-out programs had a 96% participation rate, where opt-in programs only had about a 58% participation rate. Yes, the employer might not like it as much (they have to shell out more to their employees), but it is huge for the employees, and it will most likely save the government money down the road, with more individuals being able to support themselves in retirement.

Stop the Borrowing

Beyond not participating in your company’s 401(k), the next biggest mistake you can make is taking a loan from your 401(k). Some people say, “Well, you are technically borrowing from yourself, and paying yourself back with interest…” And yes, this is true. In fact, in 2010, 18% of 401(k) plan participants took out a loan. But taking out a 401(k) loan is detrimental to your financial future!

First, when you take out a loan, you stop investing that money, and lose any potential gains. While this may not seem like a big deal, over 30 years, $2,000 can compound into $40,000! That’s an expensive loan!

Second, if you lose your job, or otherwise become ineligible for the 401(k), any outstanding loan balance becomes due with a set period of time (usually 30 to 60 days). Don’t have the money to pay? Well, the remaining loan balance is treated like a withdraw, and it is subject to tax as income at your current tax rate (say 25%), plus a 10% early withdraw penalty. Say you took a $2,000 loan, well you would still be on the hook to pay Uncle Sam about $550! Didn’t have the original $2,000,? Well, I hope you at least have this, because I doubt Uncle Sam will be as nice as your employer.

Finally, what are you taking a loan out for anyway? To buy stuff? To pay off debt? If you have to get a 401(k) loan to buy something, you probably can’t afford it, so don’t buy it. See the first reason why you should get a loan, and see what it will end up costing you over 30 years. Second, if you are using the loan to pay off debt, it is important to realize that retirement savings are not allowed to be touched in bankruptcy. So, if you are that indebted that you are considering this, DON’T! You should figure out another solution to your debts, or you should declare bankruptcy. At least when it is over, you will still have your 401(k) savings!

This is a program that federal government should just eliminate. There is no reason to allow employees to take a loan from their 401(k)s. It just gets people into financial trouble.

Early Withdrawal

This is another mistake that so many people do! Similar to getting a loan, some people just want to cash in their 401(k)s! The most common time this happens is:

  1. You leave your job
  2. You need the cash

If number 2 applied to you, see the pitfalls of taking a loan above. If you withdraw early, you will be subject to taxes and penalties, and it was probably better for you to keep the money invested to start with.

If number 1 applies to you, you should consider the following options:

  • Just keep the money invested in your old employer’s plan if you have over $5,000: There is no harm leaving the money there. The money is not actually with your employer, but an investment firm hired by your employer.
  • Move the money to your new employer’s plan: this is becoming more common, simply because it is convenient for the account holder. For individuals who switch jobs every 3 to 5 years, you could end up with 6 or 7 plans by the time you retire. By moving the plan with you, you can keep everything consolidated in one spot.
  • Do a direct rollover into an IRA at a discount brokerage: this option gives you the most flexibility and investment options. You have complete control of your investments, and the investments are still tax-deferred and protected in bankruptcy.

These options are a lot smarter than just taking the cash! Too bad it is not all that clear how to go about doing this when you switch jobs.

Not Being Diversified

For most 401(k) plan participants, this plan is the sole investment vehicle they have. They also just set the investments and forget about it, and many people don’t realize, but most companies give the employer match as company stock, not just cash. As a result, after years of investing, most 401(k) participants are not diversified. Instead, they have big holdings of company stock and other funds.

Diversification is not letting any single stock account for more than 5 to 10% of your portfolio. Say something bad happens to your company. If you have a large holding, you could see your retirement savings cut in half!

The simple solution is to re-balance your 401(k) annually or semi-annually. Yes, this is more work than most plan participants currently do, but it can amplify your returns in the future, and save you from potential losses.

Summary

401(k)s are great plans. They usually come with an incentive (a company match), they are tax-deferred, and are easy to setup. However, there are so many pitfalls and mistakes that can be made, that it is important to really think about any decisions that are made with the plan.

– The College Investor

Kevin’s Take: I only have one pet peeve about 401ks, and it’s people who don’t contribute when their employer matches. I can understand the desire to avoid using an instrument that heavily penalizes you for taking money out early, but if your employer matches, then you can take early withdraws, pay taxes and penalties, and still have more money than you would have if you didn’t contribute (because of the employer match). I contribute to my 401k because I’m happy to let that money sit for 40 years, but I also understand people who don’t want to do that.