Our Social Security system is in crisis. Despite the fact, many people do not give retirement planning enough of a priority. This is especially true when life is hard — making it difficult to think about and plan for retirement that is 30-40 years away. However, I encourage you to stop putting your future at risk, review these 7 costly retirement saving mistakes, and put your retirement savings plan back on track today.
Just as Rabbi Hillel said it many centuries ago:
If I am not for myself, then who will be for me?… And if not now, when?
The most powerful ally and the worst of enemy of any saving and investment plan is time. Let us take a look at two fictional characters, Jim and Kramer. Both of them graduate from the same college and are of the same age. Jim is a saver and started contributing $1,200 per year to his IRA account at the age of 21. Kramer on the other hand enjoys life to the fullest and did not start saving until he finally settled down at the age of 35. Kramer figures he could save $3,000 per year and make up the differences. Now let assumes both keep the same pace of saving until they turn 65.
At an average annualized return of 10% (e.g., invest in an S&P 500 index fund), here are the results:
So, it is clear that you should start saving as soon as you can. Even $100 a month can turn into a million.
Many companies provide matching contributions to their 401k plan. Now let us look at Jim again. He actually has a job with company that matches 50 cents for every $1 Jim put into his 401k (up to 3% of his $40,000 salary). So Jim is fully taking advantage of this benefit and contributes $1,200 per year. For every dollar Jim put into the plan, he is saving $1.50! — an instant 50% gain on his investment. Where will he be at the age of 65? $1,423,000— nearly $500,000 more in his retirement savings! (scenario 2)
If you employer offers 401k with matching contributions, you should make adding money to this account your top priority. At the least, you should contribute enough to fully take advantage of the match. Do not leave any money on the table. It is free money, and it is yours.
Bonus: Your employer matching contributions does not affect your 401k contribution limit. For example, you can contribute the maximum $16,500 in 2011 and still get employer matching on top of that without violating any IRS rule.
As you get your pay raises, your priority should be keeping your living expenses the same (or lower it) and increase your retirement savings. Many people make the mistake of spending their raises before they even get them. Let say Jim initially makes $40,000 per year and get a meager 2% raise each year. However, he made a point of saving his entire raise into his 401k and IRA, keeping the same $40,000 life style. This means Jim will be increasing his contribution every year until he reaches the contribution limits of $20,000 (I am using $15,000 for 401k and $5,000 for IRA for our discussion) at the age of 41.
At the age 65, Jim would have saved $7,387,000! (scenario 3) This is 5 times the amount he saved in scenario 2.
Even if Jim just manages to increase his contribution by 5% per year, he still would have saved $2,530,000 (scenario 3B).
Here you can see all the different scenarios:
Note: You can get the Excel retirement planning spreadsheet here.
Most 401k plans allow you to borrow against it. However, you should avoid this pitfall. Here are some reasons why:
Here are some more write ups on the danger of borrowing against 401k: 7 Reasons Why Borrowing From Your 401k is Bad, Bad, Bad! and Borrowing from 401(k) can be easy, but costly.
This is a huge mistake I alluded to earlier. Cashing out of 401k or IRA before the eligible ages of 55 and 59.5 (respectively) will result in 10% early withdrawal penalty, on top of the taxes you have to pay on the withdrawn amount. As such, you should not touch your retirement funds until your reach the eligible age.
If you change employer, you have 3 choices to avoid cashing out:
Of the 3 choices, I like the last one best because it opens up your investment choices tremendously. You are no longer limited by the few selections that your 401k plan offers. Most importantly, you can invest in exchange-traded funds and have more options to reduce your investment expenses. I like the first choice least because you are now have multiple 401k plans, and you might not get the premium services you used to get as an employee.
I cringe every time I hear my colleagues invest their entire retirement savings in a bond fund, or worse yet, keep it in cash. For young people, it will be decades before they withdraw money from 401k. Even for people who are near retirement, their retirement may last 20 or more years.
With retirement savings, you should invest as aggressively as your ability, willingness and need to take risk allow. At the very least, your performance should match the S&P 500. Otherwise, your investment may not grow quickly enough to support your retirement.
The rule of thumb is you should have at least 120 minus your age as a percentage of investment allocated to stocks. For example, I am 33 now so I should have at least 87% (120 minus 33) of my retirement savings invested in stocks, and 13% in bonds or money market. Currently, I am even more aggressively invested in the stock market than this.
Another horrible mistake I hear about all the time are:
Just because you have a long time horizon, does not mean you should be reckless with your money. As a rule of thumb, I do not recommend investing more than 5% of your retirement portfolio in your company stock; especially 401k. Just imagine for a minute that you were an Enron employee with half of your retirement savings in Enron stock. How would you like to lose your job and half of your retirement on the same day?
Secondly, I know that it is hard to beat the S&P, but diversification and asset reallocation is a hard combination to beat. Not only is it safer than a pure index play, you are more likely to get a better performance out of a well diversified portfolio.
Here are some decent asset allocator tools: CNN Money Asset Allocation Wizard, Wells Fargo Asset Allocation Calculator, and Principal Financial Group Retirement Simulation Analysis.
Reviewed and updated May 10, 2011.