7 Costly Retirement Savings Mistakes to Avoid

Our Social Security system is in crisis. Despite the fact, many people do not give retirement planning enough 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.

1. Waiting too long

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 start 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 settle down at the age of 35. Kramer figures he can 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:

• Jim will end up with $950,000 — nearly a million saved with only $1,200 per year contribution (scenario 1, Jim)
• Kramer will end up with $600,000 — just slightly more than half of what Jim saved (scenario 1, Kramer)

So, it is clear that you should start saving as soon as you can. Even $100 a month can turn into a million. If you do not believe me, you can read about how a janitor and a 5th grade teach with meager incomes saved $2 million at Dough Roller’s 5th Grade Teacher Discusses Retirement.

2. Leaving money on the table

Many companies provide matching contributions to their employees’ 401k. 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 saving! (scenario 2)

So, if you employer offers 401k with matching contributions, saving to this account should be 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 $15,000 in 2006 and still get employer matching on top of that without violating any IRS rules.

3. Not increasing your contribution

As you get your pay raises, your first 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: Get the Excel retirement planning spreadsheet here.

4. Borrowing from your 401k

Most 401k plans allow you to borrow against it. However, you should avoid this pitfall. Here are some reasons why:

• Some plans do not allow you to contribute while you have a loan outstanding.
• You disrupt your investment growth rate.
• You pay yourself back with after-tax money. Let say you borrowed $10,000 from 401k, at 25% tax rate, you effectively have to earn $13,333 to pay back the $10,000. Worse yet, your $10,000 gets taxed again when you finally withdraw your money at retirement.
• If you quit or lose your job, you will have to pay the remaining balance right away or risk paying the 10% early withdrawal penalty.

Here are some more write ups on the danger of borrowing against 401k: 7 Reasons Why Borrowing From Your 401k is Bad, Bad, Bad!, Warning: 401(k) loans are hazardous to your wealth and Borrowing from 401(k) can be easy, but costly.

5. Cashing out early

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 the eligible age.

If you change employer, you have 3 choices to avoid cashing out:

• Keep your money in old employer’s 401k plan
• Roll your money into new employer’s 401k plan
• Roll your money into your own Rollover IRA account

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 service you used to get as an employee.

6. Investing too conservatively

I cringe every time I hear my colleagues invest their entire retirement savings in bonds or 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.

7. Putting all your eggs in one basket

Another horrible mistake I hear about all the time are:

• “I keep 50% of my retirement portfolio in the company stock”
• “I put all of it in S&P 500 Index fund”

Just because you have a long time horizon, does not mean you can 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 saving 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. Case in point, both of my IRA and 401k were able to bet S&P 500 since 2001 because I have holdings in international funds. With explosive growth in developing countries, such as China, and the weakening U.S. currency, these funds have outperformed my U.S.-based investment handily. However, I keep my portfolio balanced by doing a yearly asset reallocation to make sure I am not over invested in any particular area.

Here are some decent asset allocator tools: CNN Money Asset Allocation Wizard, Wells Fargo Asset Allocation Calculator, and Principal Financial Group Retirement Simulation Analysis.

Lastly, I want to leave you with a few good posts I found on the subject of retirement:

• My Money Blog: 4 Ways To Tell If You’re On Track For Retirement
• QueerCents: Career & Money Part 11: Retirement
• Advanced Personal Finance: Replacing Income In Retirement
• Consumerism Commentary: Do You Need 80% of Your Current Income in Retirement?

This article was featured in the 114th Carnival of Personal Finance hosted by The Simple Dollar.

Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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