6 Dumb 401(k) moves
1. Cashing out when changing jobs
Probably the worst thing you can do with a 401(k) is to take a distribution from it when you change jobs. There are negative tax consequences, you undo lots of good (and easy) work saving for retirement, and you probably don’t need the money anyway.
The major negative with taking a distribution from your 401(k) when you change jobs is the tax consequences. When you take a distribution before retirement (with some exceptions which are rigid in their requirements), you are immediately hit with a 10% penalty by the IRS. In addition, the distribution now becomes ordinary income, meaning you’re then taxed on the distribution.
The second reason not to take an early 401(k) distribution is because you’re undoing a lot of good work you’ve done for your retirement. When you had money taken out of your paycheck and put into a 401(k), you’ve already done the hard part. Any pain you may have felt in having a smaller paycheck has already passed. If you take a distribution, you’ve just undid all your work.
Finally, you probably don’t need the money anyway. Unless you’ve been involuntarily separated from your company, you either have another job lined up or plan on something else like going back to school. In either case, you most likely don’t need a lump sum of money right now. Can we all make use of a big deposit into our checking account? Of course, but you weren’t planning on it, so its absence won’t hurt.
2. Leaving your contributions in the default option.
Many people think their work is done when they elect to have money put into a 401(k). They give no thought to a very important next step - asset allocation. Your choices may be precious few or confusingly many, but leaving the money in a default money market account (or worse, company stock) is akin to giving away money. By doing so, you’re letting inflation eat up your hard earned money. Please don’t leave your contributions in a low-yield investment, but do be cognizant of your time horizon and invest appropriately.
3. Taking a loan against it.
Taking a loan against your 401(k) is touted as a good idea if you need money. It’s not - it’s dumb. According to the Employee Benefit Research Institute, 1 in 5 401(k) participants has an outstanding loan. People like to say that having one is a good idea because, “you’re paying the interest to yourself.” That’s misleading and here’s why. When you take a 401(k) loan, you pay interest but that interest, along with the principle, goes back into your 401(k) account. The problem is that while your loan is outstanding, your money isn’t working for you. It’s not invested in the markets, so you’re likely losing money.
The other reason taking a 401(k) loan is dumb is that if you leave your job for whatever reason, you typically have to pay that money back immediately. If you needed a loan, you didn’t have the money to begin with, so you’ll likely have to take the loan amount as a distribution with all the nasty consequences that go with it.
4. Not periodically rebalancing.
One of the principles of investment is periodic rebalancing of your portfolio. To rebalance is to sell winners and buy losers so that you return to your original asset allocation. If you don’t rebalance your 401(k), your asset allocation gets out of whack and your not investing as you intended. You don’t have to rebalance constantly, but once or twice a year is probably adequate.
5. Investing in company stock.
Another dumb 401(k) move is investing your contribution in company stock. If you work for a public company, the employer match you get is almost certainly invested in company stock so you have exposure there. Furthermore, you obviously work for that company, so your income already relies on its welfare. Further increasing your exposure by voluntarily buying company stock in your 401(k) is foolish.
6. Checking it obsessively.
Do yourself a favor and don’t check your 401(k) daily, or weekly for that matter. The purpose of your 401(k) is to invest for retirement, which is probably years away. There’s simply no need to know your balance on a constant basis. Research shows that people who check their investments very often trade often and people who trade often have lower returns than those who don’t.
April 23rd, 2007 at 3:20 pm
I’m curious someday to do the math on the 401k loan.
It seems like that requires making some pretty significant assumptions about the expected rate of return on your 401k balance and the interest rate you’d be paying.
If the choice is between borrowing from your 401k, and paying it back with perhaps 7% interest, or borrowing against a credit card and paying 13%, I’d bet that borrowing from the 401k will come out well ahead.
Your other point about borrowing is a good one. Many plans (though not all) require repaying immediately. My company’s plan does not require an immediate repayment, but I bet that they’ll keep you from rolling the account into a traditional IRA until the loan is repaid.
April 23rd, 2007 at 9:52 pm
The cashing out when moving jobs is the worst. I have been the administrator on accounts where people do htis, and you just want to shake these people and say, “This is retirement money - you will need this some day!”
April 23rd, 2007 at 9:54 pm
The other thing that people would do is leave their money in the money market option. I think some did this unintentionally - they somehow never chose investments, or their investments were phased out, they were mailed letters stating they’d need to choose new investments and never did, or something like that. But scary as it is, I think some people invested in the money market on purpose. Not exactly the fast track to retirement!
April 24th, 2007 at 2:15 am
April 30th, 2007 at 5:19 am
The MOST idiotic thing about taking a loan from your 401(k) is that it entirely defeats the purpose of tax deferment!
Say you have a 401(k) and you take $15k out of it to buy a car. Well, when you pay that loan back, you’re paying it back with after-tax dollars. Say the loan payment was $500 a month. Well, to have that $500 to make the payment, you’d have to earn about $600 at your job because it would be taxed. But then, when you go to take your 401(k) money out in retirement, you’re going to take that $500 a month payout and then pay taxes on it, so you’ll keep about $425 of it. That means you earned $600 at your job to get $425 out. That’s a 30% tax rate when you’re in a 15% tax bracket.
In the end, even if you’re in a low tax bracket, taking a loan from your 401(k) is a 10-15% minimum penalty on your returns on whatever loan amount you take. Add in the lost earning time, fees collected for the loan, etc. and you’d definitely be better off with an installment consumer loan and probably even with a moderate interest rate credit card (if it was that critical).
May 1st, 2007 at 8:02 am
[…] never taken a loan or cashed out a 401(k). One of the dumbest things you can do with a 401(k) is take a loan against it or, worse yet, cash it out when you leave an employer. Both times […]