If You’re Making This 401k Mistake Your Retirement Dreams Could All Go Up In Smoke

Here’s a hypothetical situation for you to consider:  What would you do if someone walked up to you and offered you an envelope full of cold, hard cash with no strings attached?  Would you take the money and run like a mad man or woman?  Or would you say “no thanks” and merrily go on your way without giving it a second thought?

You might think it’s a silly question or that I’m off my rocker.  After all, who would be crazy enough to turn down free money?

But the truth is that there are millions of people who are doing exactly that, and you could be one of them and not even know it!

According to a recent report released by AON Hewitt, 29 percent of 401k participants are not contributing enough to receive the full employer match.   In other words, their employer is offering them free money and they’re turning it down.

Employer Match = Guaranteed Return

Employer matches can vary from one company to another.  Some employers are extremely generous while others don’t offer any match at all.  But just for an example, let’s say you work for a company that offers a 100% match on all of your 401k contributions up to 5% of your salary.  Let’s also assume you earn $50,000 in salary.

If you contribute 5% of your salary each you’ll be putting a tidy $2500 a year into your 401k account.  But since your employer is matching those contributions your account will actually be growing $5000 a year!  That’s an instant return of 100%!

While 401k plans aren’t perfect (they are often laden with hidden fees and it can be tough to get your money out if you need it) but they do offer substantial tax benefits and an employed match is just too good to pass up.  If at all possible, you should increase your contribution rate at least enough to receive the full employer match.

The following is a guest post by Lisa Cintron.

With the present economy and the state of Social Security the way it is, millions of American families are wondering how, or even if, they can realistically save enough for retirement and send their children to college. The simple answer is yes. But it won’t come easily for most; you will need to work hard and maybe give up some things. You will also need to teach this to your children–something older kids might balk at, but will be appreciative of as adults.

Here are five steps to get you started on the path towards giving your children a great education while securing a good retirement for yourself.

1. Fund Retirement Accounts: A good rule of thumb is to invest 15% of your take home pay for retirement planning. There are no scholarships for retirement. If need be, your kids can take out student loans. Your first priority is to yourself. The longer you delay saving money, the more compound interest you lose out on. If you are debt free you should contribute to your retirement accounts to get your employers match, if any, and up the maximum allowed. Outside of 401ks you can invest in mutual funds or index funds which are great for long term savings. Consult your financial planner to learn what is best for your situation.

2. Fund College Accounts: After you make sure that you have taken care of yourself, start funding Educational Savings Accounts (ESA), or other college savings accounts, for your kids. The younger they are when you start this, the more time the money has to grow thanks to compound interest. Let your kids know that you are saving for their education but that they may also need to contribute when the time comes.

3. Tighten Up Your Budget: If you find that you just don’t have the money to fund retirement and college savings, look over your budget. If you don’t have a budget, now is the time to create one. Find out where every dollar is going. You may be surprised to see how much you spend on one area. If possible cut back wherever you can and direct that money to your savings goals.

4. Take On Part Time Work: Maybe you have tightened your budget as much as you can. This does happen. There is a limit to how frugal you can be, but is isn’t too difficult to get a part time job to earn more income. Deliver pizzas or newspapers, have a garage sale, scour the second hand shops and sell your great finds on eBay. There really is no limit on how much you can earn.

5. Involve Your Kids in Family Finances: If you haven’t yet, get your kids involved in budgeting and showing them how much it costs to run a household. While they won’t get any say in most of it, they can learn how to write checks, balance the budget and how interest works. Explain your savings goals to them and turn saving into a game. If you give them weekly allowances, help them to budget the money so that they don’t blow it all on candy.

And finally, consulting with a qualified financial advisor to help execute your plan is always a good idea. There may be some creative financial plans that you may not be aware of, however an advisor can guide you through the treacherous road of financial planning.

The Three Legged Stool Is Looking Pretty Beat Up These Days

My first real job out of college was in the benefits department of a large retirement services company.  The first thing I did was spend an entire week in new-hire training, where we learned all about the different types of plans we administered.  And I still remember one of the first things we discussed was the three legged stool of retirement planning.

The three legged stool is an old image that was meant to demonstrate the different sources of income a retiree could rely on. As the image below suggests, the 3 legs represent Social Security, company pensions, and personal savings.

Do you see a problem with this picture?  Let’s take a look at each leg and see where we stand…

Company Pensions

The days of spending 40 years working for the same company and then retiring to collect your gold watch and pension have pretty much gone the way of the dinosaurs.  Traditional company pensions that promised a defined benefit are all but extinct, replaced by 401k plans in which the onus for savings is placed firmly on the employee.  In other words, people who previously had their retirement taken care of for them now need to learn how to save money for themselves. (Read more about defined benefit vs defined contribution plans).

Now 401k plans are a great way to save money and they offer some tax advantages, but they require participants to contribute their own money instead of strictly company money.  Plus, the average participant receives little education on how to maximize their earnings so they end up making a variety of 401k mistakes which cripple their earning power.  So when you step back and look at that first leg it looks like it was broken in half and then repaired with some 401k glue.  Will it hold?

Social Security

I’m sure you’ve heard one of the many warnings that Social Security is on the road to insolvency and benefits will have to be drastically cut.  Many young workers worry there won’t be anything left by the time they retire.

I can’t see the future but I also can’t imagine the government allowing Social Security to go completely belly up.   They may cut benefits or tax us more to pay for them, but I believe there will be something.  Unfortunately there’s no way to know what it will be, so it’s hard to really rely on that second leg.

Personal Savings

Before the recession, US savings rates were hovering around 1 to 2 percent.  Those numbers have since increased to around 6 to 8 percent, but that’s still not enough.

How much should you save?  That is a tough question to answer.  The general rule of thumb is 10%, but that’s just a guideline.  JD Roth thinks you should save 20%.  Dave Ramsey says 15%.  You have to look at your own financial situation to determine what is best for you.  But especially considering the weakness of the first two legs of the three legged stool, it is absolutely vital that you save as much of your income as you can.

When you look at the balance in your 401k account, do you start to get depressed?  Do you panic and worry that you’ll never have enough saved to retire and enjoy the finer things in life?  If so, you’d better start whipping your retirement savings into shape!  Here are some tips to help you make the most of your 401k.

1 Participate.  I know it sounds like common sense but millions of people who have access to a 401k plan are not taking advantage of it.  If you don’t put anything in then you can’t act surprised when there is nothing there to take out.  And the sooner you start contributing the more time your money will have to grow.  If you know anything about compound interest, you’ll know that even a few years of procrastination can have a huge impact on your savings.

2 Take the Company Match.  Many companies will match a certain percentage of your contributions.  For example, let’s say they match 50% of your contributions up to 6% of your salary.  That means that while you’re contributing only 6% of your salary, a full 9% is being deposited into your account.  That’s free money and you’d be a fool not to take advantage of it.

3. Leave it Alone!  Your 401k is meant to be used for retirement savings, not as an ATM machine.  Yes, there are loans and hardship withdrawals that allow you to take some funds out, but you should only do so after exhausting all other avenues.  Anytime you take money out of your 401k, you’ll miss out on all the earnings those funds could have accrued.

4. Diversify.  Your 401k plan probably has a dozen or more investment funds to choose from and I don’t blame you if you can’t make heads or tails out of the selections.  But you need to take the time to learn about them so you can diversify your funds to maximize growth potential while minimizing risk.  For example, if you invest everything in a money market fund your returns will be minimal and you’ll never have enough to retire.  But if you invest everything in risky company stock you could lose it all.  You have to find the right balance to meet your individual needs, which is easier said than done.  Fortunately many 401k plans include age-based funds which will automatically adjust their allocations as you get closer to retirement age.

5.  Take it With You.  Far too many people cash out there 401ks when they change jobs and that’s just a bad idea.  Not only will you pay taxes on your distribution, but if you cash it out early then you’ll have nothing left when you need it.  401ks are portable, which means you can take them with you when you leave a job.  You can either roll them into a 401k with your new employer, or into an IRA.  Either way your money will continue to grow until you are ready to retire.

Employer-sponsored retirement plans can basically be divided into two categories:  defined benefit vs defined contribution.

In a traditional defined benefit pension plan, an employee receives a set monthly amount once they reach retirement.  The amount they receive is based upon the participant’s salary and length of service with the company.  They continue to receive that amount (plus cost of living increases) every month for the rest of their lives.

In contrast to traditional pensions where the amount of the benefit is defined, most workers today participate in defined contribution plans like 401ks.  DC plans get their name because it is the amount of the contribution that is defined instead of the benefit.   Employees contribute a portion of their salary into a retirement account where it can be invested in stock, bonds, mutual funds, etc.  Some companies make a matching contribution up to a certain percentage.  The account grows through contributions and investment earnings until retirement.   In a DC plan, there are no guarantees how much (if any) of your money will be left when you retire.  If you make poor investment choices you might not have anything at all.

Today defined benefit plans are practically extinct in the private sector.  Most companies that do have a traditional pension plan only keep them open for long-time employees who were grandfathered in.  New hires are enrolled into a defined contribution plan instead.

Why the switch from defined benefit to defined contribution?

In a word…sustainability. As more and more workers retired and began collecting benefits, companies had to devote more and more resources to pay for those promised benefits.  Before long they were crippled by the enormous payments they had to make to fund the pension plan.

And it’s not just the private sector that is affected, government pension plans are now being targeted for reform.  New Jersey governor Chris Christie is one of the loudest proponents for pension reform

“I know these reforms will not be popular with everyone,” said Christie. “I also know that failure to follow through with dramatic pension reform will imperil the system for everyone, and that failure to control and share costs of health care benefits will continue to eat away at our state and local budgets. We must reverse the damage caused by fairy tale promises that have fattened benefits and pensions to unsustainable levels while ballooning unfunded liabilities to breathtaking levels.”
-source http://njtoday.net/2010/09/15/christie-unveils-pension-reform-plan/

Those are strong words and only time will tell how successful Christie will be in implementing reforms.  But I have to give him credit for trying to tackle the issue instead of sweeping it under the rug and leaving it for “the next guy” to worry about.

This is a guest post by Lisa from http://get401krolloverinfo.com.  Lisa discusses 401k plans and the importance of investing early.

When we are little we start thinking about our future. We start thinking about things like what we want to be when we grow up or where will we live, but you never hear kids talk about how much money they will have when they retire. That is of course because as kids they don’t even know what retirement is, but as we start getting into our late teens and early twenties we start to learn about retirement and understand that we have to plan for our future. We start to realize that what we do today plays an important role in where we will be tomorrow. That is why investing in your 401k retirement fund at an early age is so important. You are planning for the future. What you invest today will greatly impact your quality of life 30, 40 or 50 years from now.

From your very first job to your very last, you should be investing in your employer’s 401k plan if it is provided and here are 3 simple reasons why:

• If your employer matches a certain percentage of your contributions then you definitely want to invest because you will be receiving free retirement money from your employer. You want to invest at the very minimum enough to get your companies matching contribution.

• When you invest in a 401k plan you are using pre-taxed dollars, which means Uncle Sam has yet to get his hands on your money. This means that every penny that you invest gets put to use. Over time your money and the interest that it has earned compounds and continues to earn more interest. So for example if you invested $1 and you earned $.25 in interest on that $1, you now have $1.25 earning interest, as opposed to just $1.

• It’s automatic, which is important when it comes to saving! Some people set a budget and commit to putting a certain percentage into savings each paycheck, but it is too easy to not follow through. Your 401k contributions are automatically taken out of your paycheck each week (before taxes) and are invested. There is no opportunity for you to take that money and spend it on something else, like shoes, clothes or a new gadget.

Investing in your employer’s 401k plan the minute it is available to you is one of the most important steps you will take for your future. You are saying to yourself and to your employer that your future is important. Just as investing is a priority keeping up on your 401k plan is equally as important. You don’t always want to just set it and forget, and here are 2 reasons why.

• You want to make sure you are getting the most bang for your buck. Each quarter you will receive a statement that shows you how your investments are performing and it’s important to really take the time to learn and understand what your investments are doing for you. If you are unsure you may want to consider meeting with a financial advisor or someone you know that is very savvy with investing to help you get a better understanding. Going over the statement each quarter will help you determine if you are investing wisely.

• If you decide to go work for another employer you need to make sure you put your 401k plan at the top of your priority list and do not forget about it. You have 3 options available to you: Perform a 401k rollover, cash out your money or leave it with your previous employer. It is important to understand all 3 options. Cashing out your 401k before the age of 59 ½ will result in hefty taxes and penalties. If you leave your money with your previous employer they may charge you account maintenance fees. Performing a rollover to your new employer is usually the best option because you will only have one account to maintain as opposed to several.

So if you are not investing in your company’s 401k plan, do so as soon as possible. If you currently have a 401k, take the time to understand your investments and make sure they are working well for you at your current age. Don’t just set it and forget it. Make sure you are on track to retire healthy, wealthy and wise!

Lawmakers are considering legislation that would delay eligibility for full Social Security benefits until age 70 for millions of young Americans.

Today the full Social Security benefit retirement age is 66 for people born between 1943 and 1954.  It gradually increases by 2 months per birth year until reaching age 67 for those born in 1960 or after.

I’m only 33, so if the retirement age is delayed to age 70 I will certainly be affected.  But you know what?  I think I’m ok with it.

Let’s face reality.  The Social Security program is in serious trouble.  According to the Trustees Report, the Social Security trust fund is scheduled to run out by 2037, at which point there will only be enough taxable income to pay about 75% of scheduled benefits.

It’s obvious that something needs to be done, and since life expectancy is much higher today than it was back in FDR’s day it makes sense that the retirement age is adjusted accordingly.

But I don’t think that’s enough.  I’d also like to see an increase in the taxable maximum.

Social Security is financed through a dedicated payroll tax. Employers and employees each pay 6.2 percent of wages up to the taxable maximum of $106,800 (in 2010), while the self-employed pay 12.4 percent.  So if you make less than the taxable maximum your entire salary is taxed.  But if you make more than that, anything over the maximum is not taxed.

I’ve never really understood why the burden of paying for Social Security was almost entirely on the shoulders of the working class.  Why should a middle class worker making $106,800 pay the same amount ($6,621.60) in Social Security taxes as LeBron James?

You don’t think the wealthy are using smart Social Security strategies to ensure they receive the benefits they’re entitled to?  Of course they are…they didn’t get wealthy by making poor financial decisions and leaving money on the table.

I say up the taxable maximum.  It will increase the amount of taxable income without devastating the middle class and working poor.  And it will help insure that Social Security benefits are still around for the people who need them most.

What are your thoughts?  Are you willing to push your retirement back a few years or pay more in taxes if you earn over the taxable maximum?

The road to retirement is long and winding. It’s filled with speed bumps, potholes and dead ends. Some of the obstacles we face are largely out of our control. A natural disaster, job layoff, or debilitating illness can lead to financial ruin and there is little you can do to predict or avoid them.

But there are many other potholes you can avoid with careful retirement planning and wise decision making. If you can avoid the seven pitfalls below you will be in better shape than most.

1. Not calculating how much money you will need in retirement. Hopefully you are already setting money aside for your golden years, but are you sure it will be enough? Most people seriously underestimate how long their retirement will last and how much cash they will need to support themselves. They run the risk of using up their savings too soon.

Since each of us will have different needs and circumstances come retirement, I can’t give you a magic number that you need to save each month. But there are dozens of online calculators that you can use to determine your optimal savings rate.

2. Not starting early. When we’re young and just starting out, retirement seems like it’s centuries away. We tell ourselves that we’ll have plenty of time to build our savings later, and that we need to worry about the mortgage and the kids for now. But before you know it a few years slip by and retirement is a lot closer than you realized.

Is it too late to start saving? No.  It’s never too late. But you may have already missed out on years of savings and compound interest.  Start early.  Start today.

3. Not taking advantage of all the tools at your disposal.  While saving for retirement can seem like a daunting task, you do not have to go it alone. There are tools that will help you grow your savings quickly.

Does your employer offer a 401(k) plan? Contributing to a 401(k) not only adds to your savings of tomorrow, it lowers your tax bill today. That’s a double winner.

Plus,  if your employer offers matching contributions your savings will grow even faster.  Say you’re earning $35,000 a year and you contribute 10 percent of your salary ($3,500) to a 401(k) plan. A typical employer match would be around 50 percent on the first 6 percent of your compensation. In this case that would amount would be $1,050. The result is that by contributing $3,500 of your own money, you have received a total of $4,550 toward your retirement. That’s just too good of a deal to pass up.

If you are not eligible for a 401(k) plan, you can contribute to an Individual Retirement Account (IRA) instead.  IRA contribution limits are less than those of a 401k and you won’t receive any matching contributions, but your account will grow on a tax-deferred basis until you retire.

4. Cashing out early. The days of spending one’s entire working career with the same company are over. In today’s world, it is common to jump from one job to another.  But far too many workers cash out their 401(k) plans when they switch jobs. Not only do they wipe out the retirement savings they had built up, but they have to pay income taxes on it too. Plus, if they are under the age of 59 1/2 they will pay an additional 10 percent penalty tax.

It just doesn’t make sense to save up your money for retirement and then cash it out early. Depending on your plan’s provisions you may be able to leave your 401(k) with them even after you go, but this is usually not your best option. Instead, roll your balance into your new employer’s 401(k) or into an IRA.  You won’t have to pay any taxes if you elect a rollover, and your retirement nest egg will remain intact.

5. Taking bad advice. Not everyone has the time, desire, or expertise to plan out their retirement for themselves. There’s no shame in admitting you have limitations and letting a financial adviser help you.

But choosing the wrong financial adviser can be tricky, and if you make a poor choice it’s you that will be  sorry.  Don’t just pick a name out of the yellow pages.  Ask your friends and family for recommendations.  Then interview them carefully.  Make sure they have experience and a winning track record. Discuss your goals and ask about their investing strategy. Are they too conservative or too risky for your taste?

How do they get paid?  Do they receive a commission on all trades or an hourly fee?  Do they have relationships with financial companies that could cause a conflict of interest?   These are all important things to know.

6. Paying too many fees. There are always costs involved in investing.  Execution fees, asset-based fees, expense ratios, and fees paid to a financial planner or broker are just a few of the expenses that will drag down your savings.

You can never avoid fees altogether, but you can minimize them. Look for investments with low expenses.  Index funds generally charge much less than mutual funds that make a lot of trades.

Shop around and minimize expenses.  Keep in mind that the more you pay in fees, the less you will have at retirement.

7. Retiring early. When we’re working, retirement seems like the Holy Grail.  We can’t wait to kick off our shoes and enjoy doing whatever we want.  But after awhile some retirees get bored.  By then, it’s too late to return to the workforce.

Before you decide to retire for good, make sure you are ready.  Sit down with your employer and ask if you can scale back your responsibilities and hours to give yourself more free time without retiring.  Or perhaps work on projects as a consultant instead of a full-time employee.

And remember that the longer you work and receive a salary, the longer you can go without tapping into your retirement savings.