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Common 401(k) mistakes & how to avoid them.

Don't underestimate the potential and value of your 401(k) plan. Here are some investment do's and don'ts.

A 401(k) plan is one of the most powerful and efficient ways to accumulate your retirement dollars. At the same time, it's important that you take an active role in your 401(k) to insure a secure, safe and financially sound retirement. In order to truly maximize the return on your 401(k) dollars, you need to understand the repercussions of your contribution, investment, borrowing and withdrawal decisions. The following will held you to avoid the most common mistakes participants make with their 401(k) plans.

Mistake 1. Deciding not to participate because you don't want your paycheck reduced. No matter how large or small your paycheck, you may feel there's not enough to cover your day-to-day needs. If that's your excuse for not participating in your 401(k) or just contributing the minimum amount, you fall into a major mistake category.

There is absolutely no reason not to participate in a 401(k). You can do so with a minimum reduction in your paycheck. Work with your accountant for figure how to adjust your tax withholding so that the IRS pays for much of your contribution. If a tight budget is holding you back, get more information and reconsider. You can maximize your paycheck and build a retirement portfolio at the same time. If your plan 4as a company match or profit-sharing contribution, don't wait; do it now.

Mistake 2. Investing for retirement in a regular account before maximizing your 401(k). Even if your plan has no company match, your 401(k) puts you far ahead of an investment you'd make in a savings or investment account. A 401(k) puts you ahead because it offers tax advantages and provides an environment in which the potential for compounding your investment is greater than in any regular account you might set up. Therefore, it's best to first maximize the 401(k) before investing for retirement in a regular savings or investment account.

Mistake 3. Not knowing the leverage your plan offers. If your company has a 401(k) plan that has a company match, your 401(k) has even greater potential for compounding your investment. The 401(k)s with company matches or profit-sharing contributions are the most powerful in terms of the growth potential for retirement assets. Certain features of those 401(k)s allow you to leverage" your investment without your having to take on "margin" risk. The company match is subject to vesting, which in some plans occurs immediately; in others, it occurs in your fifth or seventh year of employment, depending on the vesting schedule adopted by your plan. At the latest, by law, your company match must vest when you reach age 65 or complete five years of service if hired after age 60.

Mistake 4. Driving your 401(k) on the highway in low gear for no reason. Most plans call on the participant to figure out how to maximize the company match. Usually, there is a certain percentage salary contribution needed to trigger the maximum dollar contribution from your company. This is the optimal leverage point of your plan as it relates to your paycheck. Not knowing your optimal leverage point - one of the most damaging mistakes you can make - means that you're not maximizing the potential of your 401(k). You could be passing up a bonus of 3%, 5%, 6% or 10% of your yearly salary. When you do find out what your optimal 401(k) leverage point is, you'll find that your account can compound immediately, without the assumption of market risk.

Mistake 5. Borrowing from the plan for consumer purchases. One of the selling points of the 401(k) is that you can borrow money from your plan, which means that you are actually borrowing from yourself. As you pay off the loan, you are paying yourself back, and when you pay interest on the loan, the interest goes back into your account.

However, the loan provisions of the 401(k) were never intended to encourage consumer spending, and, from an investment standpoint, assets should work for you toward your retirement, not toward current purchases. It's important to remember that interest on a 401(k) plan loan is rarely tax deductible. You'd be better off preserving your retirement account and taking a tax deductible home equity loan.

Mistake 6. Selecting investments that have the least chance of growing your assets. The successful investor always starts with the end result in mind. Of the investment options that are presented to you in your plan, some will be better suited for the production of income and some will be better suited for growth of capital. It's important to understand the difference. If you want to grow your assets, don't pick the investment options that give you the least chance of accomplishing this result.

Mistake 7. Asking your human resources department to tell you what to do with your investments. Some participants find making investment selections for their plans overwhelming and turn to their personnel department. No matter how good their intentions, remember that you have to take charge of your own investments. It is not necessary for you to have years of experience to be successful in your 401(k), but you do need to learn about the basics of your plan and the investment options available to you. Consider retaining a professional investment advisor. Then stick with a program of investing that is best for you.

Mistake 8. Chasing the current top performers. One plan of action that almost guarantees bad results is switching holdings over to the current top performer. Top performance figures should never direct your investment activity. You simply don't buy an investment after it has made its move. It is far better to position yourself in the market and stay the course until there is a reason to reallocate your portfolio. Participate in the market by knowing its volatility characteristics, not based on your guess about the direction of the market. The worst possible way to choose investments for your 401(k) is to buy immediate past performance. The best strategy is to understand your investment options, position yourself appropriately, and stay the course until it is time to reallocate your holdings due to your position in the 401(k) investment life cycle.

Mistake 9. Taking your money out of your 401(k) when you change jobs. When people change jobs, they may not understand the magnitude of the loss they will suffer by not rolling over their 401(k)s into another tax-deferred vehicle. First, there is an income tax and a tax penalty to be paid. Second, using your retirement assets as spending money may give you immediate satisfaction, but it leaves you behind in building your retirement assets. It may be possible to make up for lost time, but only if you have substantial lead time, invest much more money and don't hit the legal limits imposed on contributions.

Mistake 10. Looking for a solution in a life cycle fund or an asset allocation fund. The 401(k) industry has created a fund that is meant to be all things to all people: the life cycle fund, or asset allocation fund. Asset allocation funds may be offered as an option in your plan. The problem with these funds is that any time you have a one-size-fits-all solution, you tend to get a baggy fit. It is far better for you to make your investment selections based on where you are in your 401(k) cycle, not where everyone else is.
COPYRIGHT 1996 Earl G. Graves Publishing Co., Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Publication:Black Enterprise
Date:Dec 1, 1996
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