For many of our parents, retirement income planning was a relatively simply affair, thanks in large part to the prevalence of defined benefit plans-more commonly referred to as pensions.
Today, those defined benefit plans have been largely replaced by defined contribution plans. Perhaps the most common type of these plans is the 401(k), and it's one of the most important tools many investors have to building a sustainable pool of retirement income.
To help ensure you're making the most of your 401(k), we wanted to discuss three common mistakes we've seen investors make with these plans.
Choosing the Default Investment Option
When you enroll in your company's 401(k) plan, your money will be invested in a default option. This is likely to be suboptimal for a number of reasons. For starters, there's a good chance that the default investment option will have the wrong allocation for your needs.
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The investment may be either too risky or too conservative based on your desired risk tolerance and time horizon.
Additionally, solely using the default investment option can limit your ability to construct a diversified portfolio inside of your 401(k). While diversification doesn't shield you from a market downturn, it can help limit your risk while giving you the potential to perform well in a variety of economic conditions.
Forgetting to Rebalance
Not all asset classes have the same performance. Many of you know instinctively that stocks tend to outperform bonds over the long term. What you may not know is that this difference in performance can cause better-performing investments to compose a larger percentage of your portfolio over time. In industry jargon, this is sometimes referred to as "asset drift."
Historically, asset drift in non-rebalanced portfolios leads to an asset allocation that is increasingly concentrated in stocks. As an example, if your initial asset allocation is 60 percent stocks/40 percent bonds, over time that allocation may become 70 percent stocks/30 percent bonds-significantly riskier than the original asset allocation-depending on how much stocks outperform bonds over a given period of time. Rebalancing regularly helps you to maintain your targeted asset allocation without taking on more risk than you're comfortable having.
Taking Out a Loan
Your 401(k) balance can be a tempting source of income if you need a quick loan, but we're hesitant to have those funds used for anything other than retirement income. While it's true that the interest rate you'll have to pay on the loan will likely be comparatively lower than other sources, there are downsides you should weigh carefully prior to taking out a 401(k) loan.
For starters, the borrowed funds aren't exposed to the market, meaning that the loaned money loses its ability to accrue compound earnings. Paying back the loan can also be inefficient from a tax perspective. While the principal is repaid with pre-tax dollars, the interest on the loan is repaid with after-tax dollars. In other words, you will not only have to pay taxes on the money used to pay back the interest on the loan, but you'll also have to pay taxes on that money when you withdraw it in retirement.
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And if there's a chance you'll leave your employer, you'll have a limited amount of time (typically 60 days) to repay the loan before you become subject to income taxes and possible penalties if you are under age 59.5.
Your 401(k) is too important to make an error that can limit its ability to reach its full potential. Remember to check in on your plan on a regular basis, and when questions arise, that's the time to solicit advice from your financial adviser.
By Bruce Helmer and Peg Webb, financial advisers at Wealth Enhancement Group and co-hosts of "Your Money" on KLKS 100.1 FM on Sunday mornings. Email Bruce and Peg at yourmoney@wealthenhancement.com . Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment adviser. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.
