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3 Overlooked Mistakes That People Make With 401k Plans

By Mark Riddix

There are a bunch of financial sites that offer lists of the mistakes that individuals make in retirement planning. Common mistakes mentioned are a lack of diversification, waiting too long to start saving, and not saving enough money for retirement. While these mistakes will definitely hurt your portfolio, there are other retirement planning blunders that often go overlooked. These mistakes are just as deadly and can leave you paying unnecessary taxes to the government. Here is a list of 3 often overlooked mistakes that people make with their 401(k):

Investing in Variable Annuities

Have you ever had anyone try to sell you a variable annuity? If so, buyer beware! A variable annuity is an insurance product in which you make a lump sum payment today in order to receive a cash flow tomorrow. At retirement age, the account owner will receive a stream of payments for a fixed time period. This time period could be 10, 20 years or until the death of the account owner. The value of a variable annuity fluctuates depending on the performance of the investment inside. The biggest advantage of an annuity is that investments are able to grow tax free. Taxes are only paid upon withdrawal. Variable annuities are terrible retirement investments because there is no point in placing them in a Traditional IRA, 401(k), or 403(b) because these plans already offer tax-deferred growth, not to mention the fact that variable annuities are fee machines. According to SmartMoney.com, “the average annual expense charge on variable annuity sub accounts has been increasing, and is currently 2.3% of assets, including fund expenses and insurance expenses.” Variable annuities are known to charge rider fees, surrender fees, administrative fees, distribution fees, and loads.

Buying Municipal Bonds

Municipal bonds can be a great investment for high-income earners that are looking for a way to lower their tax burdens. They can help lower your tax burden and provide income.  While these bonds may make for good traditional investments, municipal bonds are horrible investments for your 401(k). 401(k)’s are qualified matching plans that allow you to defer taxes until retirement. The primary purpose of municipal bonds is to offer tax-free growth. Placing municipal bonds inside of a retirement plan means that your tax-free interest income will become taxable upon retirement. Basically you are taking income that is meant to be free from all taxes and making it taxable.

Taking A Loan From Your 401(k)

Borrowing from your 401(k) is like playing Russian roulette with your financial future. You should only borrow money from your 401(k) when an absolute dire financial emergency occurs and there is no other option. 401(k) loans take money away from your golden years and add another repayment burden to your finances. The problems with 401(k) loans are as follows: 

  • If your employment status changes, the loan is immediately due within 60 days. It doesn’t matter if you are fired or quit your job, the loan must be repaid within 60 days. If not repaid within the 60 day time period, the loan is treated as a distribution and will be subject to heavy federal and state taxes.
  • 401(k) loans subject account owners to double taxation. Monthly loan repayments are made using after-tax dollars instead of the pre-tax dollars used for contributions. You will have to pay taxes a second time on any distributions taken at retirement age.
  • You lose out on potential investment growth or capital appreciation while repaying the loan. The lost years of growth can be detrimental to the overall return on your investment portfolio.
  • Remember that one of the best ways to increase the return on your retirement account is by avoiding making decisions that will negatively impact your portfolio’s growth. These are all mistakes to consider that many of us have made in the past, and we don’t want you making them, too!

    (Photo credit: MJTR)

    Mark Riddix
    Mark Riddix is the founder and president of an independent investment advisory firm that provides personalized investing and asset management consulting. Mark has written financial columns for Baltimore and Washington, D.C. area newspapers and is the author of the book, Your Financial Playbook.

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    Comments

    • http://freefrombroke.com Craig/FFB

      Are variable annuities and munis offered in many 401(k) plans? I’ve never had those options, usually just mutual funds.

    • http://ShopEvolv.com James Wilcox

      I have to disagree on one point in this post and that is about the double taxation. In my 401k plan, the money is deposited pre-tax through my employer. Also when you make the loan payments the interest is paid back to yourself into the 401k plan, not to the bank. Maybe this is unique to the plan my employer has though.

      • Mark Riddix

        Hi James,

        401(k) loan repayments are made with after-tax dollars. The money is taxed again when a distribution is taken at retirement. You are correct in that the interest is paid back to you.

    • http://www.joetaxpayer.com joetaxpayer

      The 401(k) loan can go either way. Mark, I agree that there’s risk, and if one has proven they can’t handle money by getting into credit card debt, then it’s playing with fire.
      But – if you owe money at 18%, and get your act together, by taking that 401(k) loan and pretending it has the same payment as the cards, i.e. take the monthly savings and add that to your deposits, you’ve effectively paid yourself the 18%. Tell me not one in a hundred people are that disciplined….. ok. I was hoping it would be higher. And if the funds are matched, the 5 year (typical 401(k) loan duration) outcome quite positive. No?

      • Mark Riddix

        Joe,

        If it was to stave off bankruptcy it might make sense. I see your point but I never like the idea of borrowing from your retirement to pay off credit card debt. It also depends on the monthly payment of the credit card vs. the 401(k) loan. Since the 401(k) loan needs to be repaid in 5 years, the payment could be substantially higher than the credit card debt. Also, it’s too dangerous to take a 401(k) loan in this uncertain job environment. The example that you give would work for an incredibly disciplined person.

    • Pingback: A Love and Marriage Roundup » JoeTaxpayer

    • PJ

      Another big mistake people make is maxing out their 401k. People should only be investing up to the company match. Anything else is just creating an unnecessary compound tax that will likely be much higher than your current tax bracket.

      • http://www.joetaxpayer.com JoeTaxpayer

        PJ – how you you reconcile your advice with the abysmal savings rate, and the fact that the average pre-retiree claims less than $100,000 saved.
        Your caution is appropriate for (a) those whose 401(k)s have such high fees that time simply negates the tax savings, or (b) those with such high defined benefit plans, they’re close to their pre-retirement income out of the gate. This is far from the average investor. Perhaps the top 10%, given the selection (i.e. that by definition, Mark’s readers, having an interest in finance, are not random) factor, maybe 20-25% of readers here.

        • Mark Riddix

          Excellent points Joe Taxpayer! I wouldn;t consider maxing out your 401(k) a mistake at all.

    • 4XWEEZAL

      I would respectfully disagree with the writer.
      -Which funds are you in. I mean, was it the GM fund or the AIG fund? Or maybe bernie M funds! Great returns. Was the return after or before fees? Ya, its great if your in the gold fund or something. Most of us are not.
      —If your job status changes. Its paid as ordinary income and they take taxes! Were you working anyway? Ordinary iincome is now a hefty tax? Do you think in 20 years or further that your income will be higher anyway and it will be relative.. … .I mean 8k pretax in 1979 is not 8k in 2012.
      —paying back loans… Yes all money is paid on loans with after tax dollars…… True, but if you bought a house with a loan, wouldnt that also be after tax dollars?….. I mean, you gonna guarantee a rate of return on those dollars greater than my mortgage rate? There are finite dollars in peoples lives. Paying the monthly mortgage are real dollars that is paid every month. You pay interest on mortgages. ….but If you look at the funds over the last decade, they didn’t do even as good as government bonds..My investment horizon is not from 1930..You miss a good window in the market and your averages are in the toilet. That is, asssuming you actually know whats in your fund and was gamed by the fund managers to show a higher return than actual. How many dogs were kicked to the curb claiming these returns. Get me into a fund for 2-3 years and I can show it as part of my 10 year return….not the investors return that is.

      Sure 401ks have their place, but to think that its your greatest asset..Well, I think you might find out when your 401k turn s into a 104 k. You want to play investment roulette with europe in the tank and a massive baby boom population pulling their money out over the next decade or so…BE MY GUEST!

    • Danny

      What about a Variable Annuity like Metlife where someone wants to never touch the IRA but the gov’t makes them take RMD’s at age 70.5. If they are earning lower than 3.65%, the RMD will lower the principal amount to the bene’s. The death benefit rider for Metlife allows RMD’s to come out and pass on the original amount to the bene’s regardless of account value as long as it doesn’t go to zero.

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