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3 Overlooked Mistakes That People Make With 401k Plans

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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