Morningstar.com
Avoid These Four 401(k) Mistakes
Tuesday June 5, 7:00 am ET
By Christopher Davis

If you haven't noticed, the days where we can count on the government and our employers to take care of us in retirement are long gone. Social Security is on shaky financial ground, and its health could worsen as baby boomers retire. Meanwhile, company pension plans have become increasingly rare and are virtually nonexistent for younger workers. The bottom line: If you want a comfortable retirement, it's up to you.

For most of us, our 401(k)s will occupy the role that pension plans filled for the previous generation. That fact could be more than a little nerve-inducing. But there's no reason why you can't have a financially secure retirement as long as you avoid making some key mistakes.

Mistake One: Not Investing at All

Few of us could imagine turning down a pay raise or a tax cut, but a lot of folks are doing just that. If your employer matches at least a portion of your 401(k) contribution, you're leaving free money on the table. But even if your employer isn't so generous, Uncle Sam still offers a powerful tax incentive. Anything you invest in your 401(k)--as well as any investment earnings--isn't taxed until you withdraw the money in retirement. So if you're making $50,000 a year, stashing away 10% of your income into your 401(k), and paying an average tax rate of 25%, you'll save about $1,200 a year in taxes. Moreover, you'll also enjoy tax-deferred compounding on that money.

If you're not putting money into your 401(k) now, keep in mind that the longer you wait to start, the more you'll have to save later in life to meet your financial goals. Thanks to the magic of compound interest, the cost of not investing can be enormous. Let's say you begin investing at age 25, plan on retiring when you're 65, and contribute $1,000 in your first year of investing. With a 10% annual return, 40 years later that $1,000 has turned into more than $45,000. But if you wait until you're 30 to get started, that $1,000 becomes only $27,000. Waiting just five years to invest cuts your nest egg by a whopping 40%.

Given the math, it pays to start saving now. At the very least, start stashing away enough to take advantage of your employer's matching contributions and pledge to increase your contribution rate every year. Ideally, you should invest as much as you can. For 2007, individuals can contribute as much as $15,500 to their 401(k) and another $5,000 if they're age 50 or above.

Mistake Two: Investing Without a Plan

You want to avoid a mismatch between your time horizon and how you're actually investing. Recently, a friend asked me to help him with his 401(k) plan. He's 26 years old, but he had chosen his plan's "conservative" portfolio, which was overwhelmingly invested in bonds. Because he's saving for the very long haul--he's got at least 40 years until he retires--his portfolio should be overwhelmingly tilted toward stocks, which tend to generate higher long-term returns than bonds. Sure, stocks are a lot more volatile than bonds, but he's got plenty of time to ride out the bumps. As he gets older and retirement nears, my friend should become more conservative and shift more of his portfolio toward bonds.

Another friend decided he'd diversify his portfolio by investing in every mutual fund option in his plan, devoting equal amounts to each. Instead, he should've identified one or two core holdings as potential workhorses of his portfolio. These would account for at least 75% to 80% (or more) of his holdings. As the foundation of his portfolio, the emphasis should be on stability. Because he has a long time horizon, the core of his portfolio should be in equities, but he should focus on funds in the large-blend or large-value categories, which tend to offer a less bumpy ride than funds that focus on smaller or faster-growing companies. If my friend had a much shorter time horizon, he might have made a moderate-allocation fund, which invests in both stocks and bonds, or an intermediate-term bond fund his core holding. Just as with everybody else, there's room in his portfolio for niche offerings that focus on small caps, emerging markets, or high-yield bonds. But because these areas are more volatile, they're best held in smaller doses.

In the end, how you split your portfolio between stocks, bonds, and cash should hinge on your age, when you want to retire, how much you're saving each year, and your risk tolerance. One tool you can use to come up with an appropriate asset allocation is Morningstar.com's Asset Allocator tool. (This tool is available to Morningstar.com Premium Members, but you use Asset Allocator and all of the Premium features on Morningstar.com free for 14 days by clicking here). Asset Allocator simply requires you to enter in your current portfolio value, your savings rate, your age, and when you hope to retire. It then helps you figure out how much you should have in stocks and bonds, and it gives guidance on how much you should have invested in large caps, small caps, and international stocks. If it looks like you'll fall short of your goal, Asset Allocator lets you tweak each of these variables to help determine how to make it happen. If you store your portfolio on Morningstar.com's Portfolio Manager, you can use Asset Allocator to help optimize your current holdings.

If your plan offers target-retirement funds, you can avoid the fuss of choosing an appropriate asset allocation altogether. These retirement-oriented investments are designed to give investors age-appropriate, one-stop exposure to stocks and bonds. You choose your retirement date, and your plan provider does the rest. As you near your retirement, the mix of stocks and bonds automatically becomes more conservative. In the case of my 26-year-old friend who wants to retire in around 40 years, he'd choose a target-retirement fund with a 2050 date.

Mistake Three: Letting Your 401(k) Run on Autopilot

By design, 401(k) plans are supposed to be pretty low maintenance. Don't waste precious time worrying about your holdings on a daily basis. But at the beginning of every year, spend some time reviewing your 401(k). Be sure that the asset allocation you've decided on still reflects your needs and tolerance for risk. Even if you're still comfortable with your overall plan, you might need to do some tweaking. Say, for instance, you've decided to keep 80% of your holdings in stocks, with the remainder in bonds. If the former outperforms the latter for a long period of time, the proportion of your portfolio invested in stocks will end up out of whack. The same is true for asset classes. For example, small-value and real-estate stocks have gone on impressive runs in recent years, so your portfolio may have more exposure to those areas than you've intended. Periodically, you want restore balance to your portfolio by trimming your better performers in favor of the laggards. Don't worry about minor divergences from your plan. But when one of your weightings strays 5 percentage points or more from your target allocations, start cutting back. To learn more about rebalancing, click here.

Mistake Four: Borrowing from Your 401(k)

Taking a loan from your 401(k) is an example of one of those things that you can do but shouldn't. By doing so, you'll make it harder to meet your goals. The money you take out will miss out on the gains it would have benefited from otherwise. Moreover, it's a lot harder to maintain your current contribution rate if you also have to pay back your loan. You've got a year to pay back your loan, but if you don't, you'll have to pay taxes and penalties. There might be some extreme circumstances where borrowing from your 401(k) is your only option, but it should be a very last resort.