Paige Cerulli Last Updated On: October 27, 2023

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Mistakes to Avoid When Opening a 401(k)

A 401(k) can be an excellent way to help you prepare for retirement, but like any investment, it’s important to avoid some common pitfalls. Whether you already have a 401(k) or are preparing to make your first investment, taking a moment to review these potential problems could save you from making an expensive mistake.

How 401(k)s Work?

A 401(k) is a retirement savings and investing plan that is only available through your employer. Stephen Chang, Managing Director at Acts Financial Advisors, explains that while you can put money into a 401(k) in several different ways, the money grows tax-free. “You will not owe any tax on the earnings until it comes time to withdraw the money,” says Chang. “Another benefit of pre-tax contributions is that your taxable income gets lowered in the year of the contribution. This can be a great benefit for those in higher tax brackets who want to reduce their current year’s tax bill.”

Amanda Huddy, Founder of Arnie, notes that there are several other benefits to 401(k)s. “Many employers offer a match to the contributions you make, effectively giving you free money towards your retirement,” she says. “Since contributions are typically deducted directly from your paycheck, it automates the savings process.” Additionally, 401(k)s have higher annual contribution limits than IRAs, so you can maximize your retirement savings.

Common Mistakes When Opening a 401(k)

While there are many advantages to 401(k)s, common mistakes can reduce the benefits that you see from your investments. Be sure to avoid these mistakes so you get the maximum value out of your 401(k).

Limited Contributions

Chang explains that it’s common for his clients to not contribute, or to not contribute enough to their 401(k)s. “They don’t take advantage of getting the employer match, which, as everyone says, is basically free money,” says Chang.

If you have access to an employer match, review the terms of the match. For example, with a dollar-for-dollar match, your employer will match your contributions up to a certain percentage. If your employer offers a match up to 6%, then you will need to contribute 6% of your paycheck to get that full match. If you contribute 3%, your employer will only match that 3%.

Overlooking Investment Choices

Huddy notes that it’s important to regularly review your 401(k) investment choices, but many people don’t. “As market conditions and personal situations change, you should review and potentially adjust your allocations,” she says.

Chang explains that the wrong asset allocation could reduce the amount of money that you’re able to make from your investments. Mistakes like having money in a money market fund that doesn’t keep up with inflation, putting money in a fund with severe restrictions or a high expense ratio, and not having any strategy but just investing in every fund possible could cost you money.

“Make sure to have a mix of investments that align with your risk tolerance and time horizon,” says Huddy.

Cashing Out When Changing Jobs

When changing jobs, avoid simply cashing out a 401(k). If you cash out before you’re age 59 ½, your funds will be subjected to federal and state taxes, plus a 10% federal tax penalty. “Instead, consider rolling over into an IRA or new employer’s plan to keep the tax benefits,” Huddy says.

Should You Open a 401(k)?

Young professionals who are early on in their careers might be tempted to forego investments to build up cash savings, but should they open a 401(k)? “Do it,” says Chang. “Contribute as much as you’re capable and comfortable doing, and know that it’s there for the long haul. Most company plans allow you to withdraw money as a loan or in the case of hardship, but if you’re able to leave it untouched for a few decades, you’ll be far better off. So, my advice is to get into the mindset that it’s completely off limits.”

Learn More About 401(k)s

“Try to understand the basics of investing and be involved in your 401(k) decisions,” Huddy encourages investors. By staying informed, you can make more strategic decisions about your investments.

Chang recommends that investors find a financial advisor they trust and who is a good fit with their investment goals and personality. “A good professional is experienced, both personally and professionally, will answer questions patiently and thoroughly no matter how basic the question, and has your best interests in mind,” he explains.

Keep in mind that it’s important to find an advisor who is the right fit for you, and don’t be afraid to look for another advisor if the first isn’t the right match. “Ask yourself if you like working with the person and if you feel like what you say and desire is actually being heard and processed,” advises Chang. Personal finance is personal at its core, so there’s really no one-size-fits-all plan or advice that works in every circumstance and for every person.”

Paige Cerulli Paige Cerulli is a freelance content writer and journalist who specializes in personal finance topics. She graduated from Westfield State University and brings more than a decade of professional writing experience to the ConsumerCoverage team. Paige’s work has appeared in outlets including USA Today, Business Insider, and more.

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