Investment researchers identify the 3 biggest mistakes that can hinder your retirement savings in a 401(k) plan.
Does the U.S. have a looming retirement crisis on its hands?
An analysis of U.S. workers' retirement preparedness by Morningstar researchers showed both positive and negative results.
In the U.S., approximately 45% of households are predicted to face financial shortages during retirement according to Morningstar's model.
With a few key behaviors, you can increase your chances of being among the 55% who are well-prepared, with one behavior standing out particularly: contributing to a workplace retirement account.
The model predicts that 57% of households who do not participate in a defined contribution plan, such as a 401(k) or 403(b), will not be able to sustain their projected retirement expenses. This number drops to 21% for those who plan to participate in such a plan for at least 20 years in the future.
If you plan on contributing to a 401(k) or similar account for two decades or more, you're doing well. However, this number could be lower if it wasn't for mistakes made by the user, according to Jack VanDerhei, director of retirement studies at Morningstar Retirement and one of the study's authors.
He cautions that even if individuals are on track, they may still unintentionally sabotage themselves.
The 3 biggest mistakes for retirement savers
Enrolling in your employer's retirement plan promotes positive retirement outcomes by encouraging good financial habits.
Employer matching contributions are often referred to as "free money" by financial planners. By contributing up to a certain percentage of your salary, you can potentially earn a 100% return on your investment.
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By participating in a workplace plan, you're automatically investing money that never reaches your bank account, which is a widely recommended strategy for increasing your savings rate.
Generally, investors in long-term investment plans experience the benefits of compounding growth in their portfolio, but face penalties for withdrawing funds before retirement.
Workplace retirement plan investors can unintentionally harm their investments by engaging in certain behaviors, according to Morningstar researchers.
1. Taking early withdrawals
If you have a substantial amount of money in your retirement plan, you may be tempted to use some of it to achieve your short-term goals. However, taking a cash payout will typically result in a tax penalty if you are under the age of 59½ and will also increase your taxable income for the year you withdraw the funds.
Every dollar you withdraw from your long-term portfolio is a dollar that won't grow at a compounding rate.
"VanDerhei states that in certain plans for a different project, annual underlying withdrawals of 40% are being found. Therefore, treating a retirement account like an ATM machine may not result in everyone with 20 years of participation being on track."
2. Switching jobs and cashing out
When you depart from your job, you typically have the choice to roll your 401(k) funds into an IRA or transfer them to your new employer's plan. Both options will not affect your retirement readiness, but withdrawing the balance of your account in cash will, according to researchers.
If you switch jobs before age 59½, a cash-out is still considered a withdrawal and will have the same tax consequences. Additionally, it's important to note that this money is no longer in your portfolio, generating long-term returns.
VanDerhei advises to roll over the job change.
3. De-escalating your contributions
To increase your retirement savings rate without feeling a financial strain, consider setting your contributions to automatically increase by one percentage point each year. If you've been with the same employer for several years, you may have initially contributed 6% of your salary to your 401(k) and gradually increased your savings rate to 10%.
VanDerhei states that a common error made by job switchers is unintentionally or purposely reducing their contributions at their new company.
"If you switch jobs, you may be reset to a 6% contribution. To maximize your benefits, remember your previous contributions and maintain that level, especially if you are younger."
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