Your 401(k) offers a pretty effortless way to build up enough money for a comfy retirement at home, out of state, or maybe on a beautiful island somewhere.
The money comes off the top of your paycheck before you even see it, you often get free money from the boss (thanks to an employer match), and there are tax benefits. Taxes are put on hold until you withdraw the money in retirement, when you’ll likely be in a lower bracket.
But retirement accounts aren’t foolproof. It’s easy to get snagged by pitfalls that could wind up costing you thousands of dollars in penalties and lost earnings.
Avoid these common and potentially very costly 401(k) flubs.
1. Not contributing enough
To receive the maximum benefit from your retirement account — the fattest possible nest egg, grown through investments — you want to put the maximum amount into your account each year.
The 2019 limit on 401(k) contributions is $19,000, or $25,000 if you’re 50 or older. (That additional $6,000 is called a catch-up contribution, designed to help those who missed out on saving more when they were younger.)
At the bare minimum, you should be kicking in as much as it takes to get the full matching amount from your employer. Your company will likely put as much money into your 401(k) as you do, up to a certain percentage of your salary.
It’s not any kind of a requirement, but employers often do it — and not just because it’s good karma. It helps them hire and hold onto talented people (like you!), they have to keep up with competitors who match, and it gets them tax breaks.
On average, companies in 2019 are matching employee contributions to a record 4.7% of salaries, according to Fidelity Investments. Put another way, workers with 401(k)s received an average $1,780 extra from the boss during the first three months of the year — so this is one time that being all matchy-matchy would indeed be considered very fashionable.
2. Contributing too much
Funding your 401(k) is like the bidding on “The Price Is Right”: You want to hit your contribution limit without going over.
If you exceed the threshold, it can be almost as bad as going home from a game show empty-handed — without a new dinette set or billiard table.
IRS rules state that if your contributions go beyond the limit in any year, you have to remove the excess amount from your account by April 15 of the following year. The overage becomes part of your taxable income for the year when you went breezing past the boundary. Any investment earnings on that money become part of your taxable income for the year when you make the withdrawal.
But at least you won’t get dinged with the usual stiff penalty for withdrawing money from your 401(k) too early. More on that in a moment.
If you don’t pull the offending amount out of your account by the April 15 deadline, that money will be subject to double taxation — which is just as ugly as it sounds. The excess is considered part of your taxable income at the time the contribution was made, and then again whenever you eventually do make that withdrawal. Ouch, and ouch.
So, know the limit, and be careful that you don’t break through it.
3. Touching the money too early
This is one that snags far too many retirement savers. Raiding your 401(k) too soon gets very expensive, because you can owe federal and state taxes on the withdrawal plus a 10% IRS early withdrawal penalty.
What do they mean by “early”? You’ll get slapped if you touch the money before you turn age 59 ½. (How’s that for an odd birthday?)
Research shows that a third of account holders do cash out early, and that includes most younger workers between ages 18 and 34. People often do it when they change jobs, find themselves out of work, or are suddenly facing a huge car repair bill or other financial emergency.
This is why it’s so important to have emergency savings (enough to cover three to six months of living expenses), in addition to retirement savings. It’s tough, but it’s just part of the whole “adulting” thing.
Note that there are several exceptions to the 401(k) early withdrawal penalty. You might not have to pay it if:
- You’re disabled.
- You have high out-of-pocket medical expenses.
- You lose or leave your job when you’re 55 or older.
- You want to use the money for higher education.
- You’re buying your first home.
But, in other cases, think very, very carefully about whether it would be worth it to tap your 401(k), no matter how badly you think you need the money. The consequences can be costly.
About the Author
Doug Whiteman is the editor-in-chief and analyst for Wise Publishing, Inc., and its flagship personal finance website MoneyWise.com. Previously, he was an analyst and editor covering mortgages, insurance and related topics for Bankrate.com, and was the consumer news reporter for Associated Press Radio. He has been quoted by The Wall Street Journal, USA Today and CNBC.com, and has appeared on ABC Radio, Fox Business and the syndicated TV show “First Business,” among other outlets.
Blooom does not provide tax advice. Consult a tax expert for tax-specific questions.