It’s common to lay out a strategy when planning for retirement. But it’s equally important to avoid mistakes along the way.
While you’re carrying out your plans to save for retirement, you should also know what speed bumps may be out there in the future that could undo some or even all the preparations you have in place.
Let’s look at some common retirement account mistakes, and discuss how they can hurt your plan, and what you can do to avoid each.
1. Not saving for retirement
This mistake is, of course, less about retirement accounts, and more about financial philosophy. Simply put, you’ll need to approach saving for retirement with the right mindset.
Here’s why: most Americans are disturbingly unprepared for retirement.
A study by the US General Accountability Office (GAO) found that 55% of Americans between the ages of 55 and 64 have less than $25,000 in retirement savings. 41% have no retirement savings at all.
That’s not a group you want to be a part of if you can possibly avoid it.
But to avoid it, you’ll need to be intentional about your savings efforts. That will require developing a plan, implementing it, being consistent, and making adjustments where necessary.
That won’t happen by accident. Given that we live in a consumer society that relentlessly draws us to buy ever more stuff and “experiences”, saving money never happens by accident.
Even if you’re not sure how much money you’ll need by the time you retire, you should at least commit to begin saving now. Start small, if necessary, but get started. You can increase your contributions later.
2. Waiting to begin saving for retirement
This mistake is almost as bad as not saving for retirement. That’s because retirement savings success is based on a combination of three factors: Regular contributions, reasonably consistent investment income, and time.
Starting early vs. starting later
Ashley is 25 years old, earns $50,000 per year, and decides to begin contributing to her employer’s 401(k) plan immediately. She commits to saving 10% of her pay into the plan, with an average annual return of 7%. She has student loans to pay but decides she’ll invest for retirement while she’s paying down the debts.
By the time Ashley reaches 65, her 401(k) plan has a balance of $1,035,655.
Sarah is also 25 years old and earns $50,000 per year. But with school behind her and student loan debts to pay, she decides to concentrate on paying off the loans and enjoying life. She believes it’ll be better to begin saving for retirement in a few years when the student loans are paid and she’s earning more money.
Sarah finally pays off the last of her student loans and begins saving for retirement at age 35. At that point, she’s earning $75,000 per year. She commits to contributing 10% of her salary to her employer’s 401(k) plan, also with an average annual return of 7% on the investment.
By the time Sarah reaches 65, her 401(k) plan has a balance of $735,048.
Because Ashley began saving for retirement at 25, compared to 35 for Sarah, she has an additional $300,000 in her 401(k) plan by age 65.
I haven’t even accounted for the fact that Ashley’s income – and retirement contributions – would be higher than they were when she was 25 if she’s also earning $75,000 at 35 and contributing 10% of her pay. That would make her advantage over Sarah even bigger.
That’s what saving for retirement early can do for you. Begin saving as early in life as you can.
3. Not having separate retirement accounts
There’s a definite element of divide-and-conquer when it comes to saving for retirement. You never want to commingle your retirement savings with your current savings. If you do, there’s a strong likelihood the retirement savings will be spent for some purpose other than retirement.
In this way, you should think of retirement savings as a financial lockbox. It should be in an account dedicated to saving specifically for the distant future, and nothing else.
But there’s another reason why you’ll want to have separate retirement accounts.
By their nature, retirement accounts are tax-favored. With the exception of Roth plans, contributions to retirement plans are tax-deductible.
That’s a major benefit by itself. If you have a combined state and federal marginal income tax rate of 25%, and you contribute $10,000 to retirement savings, you’ll reduce your tax liability by $2,500 ($10,000 x 25%).
That will be like getting a 25% subsidy from the government for your retirement contribution.
But the other tax advantage is even bigger – tax deferral of investment income.
The long-term benefit of tax-deferred investing
Though tax-deferred sounds technical, what it means is that investment income earned in your retirement plan is not taxable until you begin making withdrawals after you retire.
What can that do for your retirement investments? Here’s a simplified example.
You’re in a 20% tax bracket, and you have $10,000 to invest. You have a choice to invest the money in either a taxable investment account or a tax-deferred retirement account.
Either option will produce an average annual return of 10%. But the return on the taxable investment account will be reduced by 20% because of taxes. That will result in an effective annual return of 8%.
What are the long-term consequences?
$10,000 invested in a taxable investment account with an effective annual average rate of return of 8% will grow to $46,609 after 20 years.
But $10,000 invested in a tax-deferred retirement account with an average annual rate of return of 10% (because it’s not reduced by the tax bite) will grow to $62,274 after 20 years.
Because of the tax-deferred investment income it offers, the retirement account value exceeds the taxable investment account by $15,665.
4. Not taking full advantage of an employer matching contribution
Many employers will match your contributions into the company retirement plan, up to a certain percentage. The typical arrangement is a 50% employer match on an employee contribution of 6%. The employer will contribute an additional 3% to your plan, giving you a combined annual contribution of 9%. That’s like getting free money!
If your employer offers a match, and you’re unsure how much you should contribute to your plan, go with the maximum needed to get the largest employer matching contribution.
5. Not saving enough in your retirement accounts
IRA accounts allow you to contribute up to $6,000 per year (or $7,000 if you’re 50 or older). 401(k), 403(b), 457, and TSP plans allow you to contribute up to $19,500 per year (or $26,000 if you’re 50 or older).
Even if you can’t contribute the full amount allowed under each plan early in your career, you should make it a goal to reach the maximum within a specific timetable.
For example, let’s say you can only afford to contribute 5% of your annual income to your employer’s retirement plan. You can commit to increasing your contribution rate by half your annual salary increase.
If that annual increase averages 2%, raise your retirement contribution by 1% per year. After five years, your contribution percentage will increase from 5% to 10%. After 10 years, it will increase all the way to 15%.
That’s a convenient and affordable way to stairstep your way to making the maximum contributions.
6. Investing too conservatively
Though investing your money conservatively can be an excellent capital preservation strategy, it’s virtually a crash-and-burn approach when it comes to investing in your retirement account.
Yes, it certainly makes sense when it comes to short-, and even medium-term savings. For example, you’ll want to have your emergency fund in the safest investment vehicles possible. Savings accounts and CDs can be perfect for this purpose. Even though they have very low rates of return, they guarantee your money will be available for that unexpected emergency.
But investing in retirement accounts is completely different. The emphasis needs to be on long-term growth and much less on capital preservation.
For example, current average interest rates are 0.04% on savings accounts, 0.06% on money markets, and 0.15% on one-year, certificates of deposit. You don’t even need a calculator to know rates that low won’t allow you to retire in 30 or 40 years.
The only way to make that happen is to invest in long-term growth. The stock market, as measured by the S&P 500 index, has average annual returns of about 10%, going all the way back to 1928.
That’s the kind of return you’ll need to have to reach your retirement investment goals. The only way to do that is by investing heavily in stocks.
That doesn’t mean you shouldn’t invest in safer assets, like bonds. But stocks need to dominate your retirement account, particularly while you’re in your 20s, 30s, and even your 40s.
7. Investing too aggressively
Despite the fact that stocks need to be the primary holding in your retirement accounts, you don’t need to get carried away.
The most practical way to invest in stocks is through index funds. For example, the most popular index funds are those based on the S&P 500. By investing in this type of fund, you’ll be holding a ready-made portfolio comprised of about 500 of the largest publicly traded corporations in the United States. That’s precisely the index that has produced average annual returns in the 10% neighborhood for more than a human lifetime.
One of the best ways to achieve the right investment balance is by using a robo-advisor to manage your money. Those are automated investment services that will create a portfolio based on your risk tolerance, then manage it for you.
In creating your portfolio, you’ll typically be invested in index-based funds. That will include a mix of between 6-12 funds that will give you complete market exposure while balancing risk. For example, those funds will usually be invested in a mix of US and international stocks and bonds, and even real estate investment trusts (REITs).
If you have a self-directed retirement account, Betterment is an excellent choice for a robo-advisor. They create a balanced portfolio for you, rebalance it to maintain target asset allocations, and even reinvest dividends.
They’ll do it all for an incredibly low annual advisory fee of just 0.25%. That means you can have a $20,000 IRA professionally managed for just $50 per year.
blooom works similar to Betterment, but specializes in managing employer-sponsored retirement plans, like 401(k) and 403(b) plans. They perform the same service as Betterment, though they will work with the investment options within your plan. They’ll move your account into the best mix of available funds in your plan, emphasizing those that have the lowest annual expenses.
For a flat fee of just $120 per year, you’ll get complete professional management of your employer-sponsored retirement plan.
8. Tapping your retirement savings early
One of the biggest mistakes you can make with your retirement account is withdrawing money early. This usually happens when you leave an employer and take a distribution of the retirement plan rather than rolling it over into another plan.
Still, another is when you have money in an IRA – but not enough in non-retirement savings – and you withdraw it to pay for the current expense.
In either situation, money that was intended for retirement is redirected into some other purpose.
That has a negative outcome on three fronts:
- You’ve reduced the money you’ll have available for retirement. I’ve already covered how investing for retirement early is a literal game-changer. That being the case, the $10,000 you withdraw from your retirement plan today may have a future value of over $100,000. But you’ll be denying yourself that future value by taking the money now.
- Early withdrawals of retirement plans are expensive. Since you get the benefit of a tax deduction on the contributions and tax deferral on investment earnings, the money withdrawn will be subject to ordinary income tax. But any distributions taken before you turn 59 ½ will also be subject to a 10% IRS penalty for early withdrawal.
- Withdrawing funds from your retirement plan early can become a habit. Retirement plans can seem like “found money”, especially if you don’t maintain other savings to tap. If you treat your retirement plan like any other type of savings, you can easily fall into that trap. What’s more, routinely withdrawing retirement money early can prevent you from building up a large balance, making additional withdrawals even more likely.
Think of your retirement account as a financial lockbox for your future self – and nothing else.
9. Repeatedly borrowing against your retirement accounts
Considering all the disadvantages of simply withdrawing money from your retirement account, borrowing against it can seem like the more benign option. But it isn’t necessarily.
Many employers allow you to borrow against your retirement plan (this is not permitted with IRAs). If they do, you can typically borrow as much as 50% of the plan value, up to a maximum of $50,000, and over a term as long as 60 months.
Since no credit qualification is required, and the interest rate is low, you may be tempted to take this option.
But here are the reasons why you shouldn’t:
The interest you pay – which is paid into your account – is probably lower than what you can earn on other investments. Borrowing will reduce the long-term value of your account.
The portion of your plan contributions that go toward loan repayment is not increasing your plan balance.
If your employment is terminated for any reason, you’ll be required to repay the loan within 60 days. If you don’t, the unpaid balance becomes an early distribution, subject to both ordinary income tax and the 10% early withdrawal penalty.
As easy and attractive as the 401(k) loan option is, tread lightly. There are costs, and they’re probably higher than you think.
As you can see from this list, a big part of your success in saving for retirement will be avoiding mistakes. I’ve covered nine of those mistakes; the more you can avoid, the better off you’ll be when retirement rolls around.