Every investor has a unique path towards retirement. In the late 1970s, Congress passed the Revenue Act, giving employees a powerful new tool to fuel their retirement: the 401(k). With tax-deferred growth and often employer contribution matching, a 401(k) can help you stay on track toward retirement. However, there are a few common errors that 401(k) owners make that can derail their retirement plan. Together, we’ll explore some 401(k) mistakes to avoid, ensuring your journey toward retirement goes as smoothly as can be.
Pitfall #1: Not Participating Fully
The first step in ensuring you are getting the most out of your 401(k) is … to use it! One of the easiest ways to increase investing success is to start early, and 401(k)s are no exception. Many employers encourage you to sign up for the company retirement plan when you start working. If you can’t enroll in your 401(k) right away, set a calendar reminder so you don’t forget to enroll later. Two common mistakes are:
- Not Taking the Match: Many employers will help you save for retirement through a 401(k) match. In general, the formula looks something like this: For every $1 you contribute to your 401(k), the employer will contribute 10 cents on top of your $1, up to a certain percentage of your salary. It is advantageous to contribute as much as you can afford into your 401(k), especially enough to maximize your employer match.
- Not Increasing Contributions: Consider increasing your contributions annually as your salary increases. Even incremental increases will add up over time. Many companies will increase an employee’s salary by 1 to 2 percent annually to account for cost-of-living adjustments. Electing to increase your 401(k) contributions by the same amount annually tends to have no noticeable effect on your current lifestyle but can make a big difference on your lifestyle in retirement.
Pitfall #2: Not Having an Investment Strategy for Your Contributions
Once you are in the habit of contributing to your 401(k), the next step is to invest your contributions. 401(k) plans offer a variety of investment options, like mutual funds or exchange traded funds (ETFs), that allow your money to participate in the ups and downs of the stock market over time. You can mix and match them according to your personal risk tolerance. Be mindful of these common hiccups when considering your account’s investments:
- Investing Too Conservatively: Money-market and low-risk securities could hinder your balance’s potential growth. Every investor has a different risk tolerance; however, risk to a certain degree is needed to take full advantage of the tax-deferred growth in your 401(k). The investment strategy you adopt into your account impacts its growth rate and your total amount at retirement.
- Making Excessive Changes in Your Portfolio: It is likely that over time your tolerance for risk and investment strategies will change. However, buying and selling securities too frequently or trying to “time the market” could severely hinder the growth of your wealth. Frequently going from one security to another could accumulate fees, dampening growth.
- Disregarding Asset Allocation: Asset allocation refers to the types of investments you own (e.g., large companies vs. small ones, utility companies vs. technology companies), and it plays a large role in your investing success. A carefully considered asset allocation strategy that aligns with your personal investing goals will be far more beneficial than trying to outperform arbitrary benchmarks like your relative, your neighbor, or the stock market. Base your asset allocation on your investment style, risk tolerance, and time horizon to help you achieve your retirement savings goal.
Pitfall #3: Dipping into Your 401(k) to Pay Off Debt
If you’ve saved diligently in your 401(k) and find yourself with credit card debt or other loans, it can be tempting to use your 401(k) funds to eliminate that debt. Carrying debt can feel like a burden, but there are several errors that will compound if you withdraw your retirement savings to use on debt or other short-term goals.
- Withdrawal Penalty: Making a withdrawal from a pre-tax account like a 401(k) before the age of 59½ means you will incur a 10 percent penalty on the amount you withdraw. In addition, the amount that you withdraw will be considered additional income, and you will owe income taxes as well. For example, suppose you need $10,000 to pay off debt. If you were to withdraw $10,000 from your 401(k) and you pay a tax rate of 22 percent, you will owe $2,200 in additional income taxes that year. Additionally, if you’re age 59½ or younger, you will incur a 10 percent penalty of $1,000. This will leave you with $6,800 to put towards debt. (To have the full $10,000 available to put towards debt at a 22% tax rate, you would have to withdraw $15,000.)
- Limiting Future Growth: While a 401(k) withdrawal doesn’t have to be repaid, it will mean you have less money available to participate in market growth to accumulate additional wealth. One of the most powerful benefits of a 401(k) is the time horizon your investments grow on a tax-deferred basis. Your investments have 10, 20, 30, sometimes even 40 years to grow and compound with no penalties or tax consequences until you withdraw.
Pitfall #4: Abandoning Your Previous 401(k)
When you change jobs, your former employer may allow you to leave your 401(k) with them. It is estimated that, as of May 2021, there were 24.3 million forgotten 401(k)s holding approximately $1.35 trillion in assets, with 2.8 million more left behind each year by people leaving jobs.1 Many American workers lose track of previous 401(k)s and lose thousands of dollars as a result.
You can consolidate your employer-held retirement savings and roll over previous 401(k) funds into your new account so you can continue to manage those assets and align them to your goals.
Pitfall #5: Withdrawing Funds Early
Contributions made to a 401(k) are meant to grow tax-deferred until you reach retirement. This allows the power of compound interest to help you accumulate more wealth to put towards future spending. A dollar saved today can be worth much more in the future but only if it stays put.
- Compound Growth: Enabling compound growth will create a snowball effect over time, allowing your original contributions AND the accumulated interest to grow progressively. One of the many benefits of a 401(k) is the long-term time horizon. The longer you allow your money to grow and work for you, the larger the potential nest egg you will have come retirement.
- Penalties: 401(k) withdrawals that are made before the account owner turns 59½ years old are subject to a tax penalty of 10 percent. In addition, money taken out of a traditional/pre-tax 401(k) will be taxed as regular income in the year you make the withdrawal. For example, if your salary is $65,000 and you withdraw $5,000 from your 401(k) or any other tax-deferred investment account, the IRS will consider your income to be $70,000 for that particular year, and you will have to pay taxes accordingly. The withdrawal penalty may also be subject to state taxes depending on where you live.
A 401(k) plan is a powerful tool for investors looking to accumulate wealth for retirement. There are numerous benefits to this tool that can turn into setbacks if not carefully managed. If you have any questions, please reach out to a D.A. Davidson financial professional.
1 As job switchers chase higher wages, they may be leaving money behind, USA Today
This material is being provided for educational and informational purposes only. D.A. Davidson & Co. is a registered broker-dealer and registered investment adviser that does not provide tax or legal advice. Information contained herein has been obtained by sources we consider reliable but is not guaranteed and we are not soliciting any action based upon it. Any opinions expressed are based on our interpretation of the data available to us at the time of the original article. These opinions are subject to change at any time without notice. Copyright D.A. Davidson & Co., 2025. All rights reserved. Member FINRA and SIPC.