By AnnaMaria Andriotis,
UNLIKE PAYING DOWN credit-card debt or a mortgage, retirement planning is a lifelong pursuit. It begins in your 20s and extends far beyond the day you exit the workplace. As a result, figuring out how much money you'll need may seem like an impossible feat.
While saving up for retirement is difficult to begin with, it gets worse. Even if you diligently stash money away for decades, one investment misstep can mean the difference between a relaxing retirement filled with days playing golf on the back nine and one that requires you to slave away at a job for years longer than anticipated.
To secure your place on the golf course, here are five all-to-common retirement mistakes to avoid.
For many 20-somethings, retirement is the last thing on their minds. According to benefits-consultant Hewitt Associates, only slightly more than half of 20- to 29-year-olds participated in a 401(k) as of the end of 2007.
Understandably, most young adults are more concerned about paying down student loans and making ends meet. But neglecting to set something aside for retirement during these early years is a huge mistake. When you invest in a 401(k), your earnings grow tax-deferred. And thanks to the power of compounding, contributions made earlier on in life will have a longer time to grow and multiply.
Assuming a 7% annual rate of return, a 25-year-old who contributes $5,000 to a 401(k) each year will end up with just shy of $1 million by age 65. But if they start putting that same amount in a 401(k) at age 45, they'll only have $205,000.
Click here for more on the benefits of starting your 401(k) early.
2. Failure to Diversify
To get the most out of your 401(k), make sure that you have a good mix of conservative (bonds) and risky (equities) investments. "A nice array of funds will really help with volatility and overall performance," explains Pamela Hess, director of retirement research at Hewitt Associates.
Investors who plan to withdraw money within the next year or two, should take a conservative approach that focuses more heavily on cash and bonds, says Lyn Dippel, vice president at Financial Advantage, a Columbia, Md.-based fee-only planning firm. Meanwhile, younger investors with plenty of years left before retirement should put a larger percentage of their money, typically around 60% of their portfolio, into high-growth stocks.
If you aren't comfortable picking your own holdings, consider investing in a target-date fund. These mutual funds are geared toward a specific age group and gradually become more conservative as its investors near retirement age. To learn more about target-date funds, read our story.
3. Mismanaging Your 401(k)
Retirement planning is no longer what it was in your grandparents' heyday. Most companies no longer offer traditional pension plans, leaving employees to shoulder most of the retirement planning responsibility, says Alan Klayman, a Holicong, Pa.-based fee-only investment advisor. Here are some ways to make the most of your 401(k).
Get the Company Match
If your company offers a 401(k) match, make sure you get it. With company matches, the employer pledges to match the employee's contribution up to a certain percentage of their salary. (Most employers match 50 cents for every dollar up to 6% of your pay, according to Hewitt Associates.) If you don't invest enough money to get the full match from your company, you're passing on free money.
Rolling over your 401(k)
Changing jobs? Don't forget to roll over your 401(k) investments to your new provider. Otherwise, if you're younger than 59 1/2, you'll get cashed out of your 401(k) only after your holdings get hit with the normal tax rate and a 10% penalty. If your new employer doesn't have a retirement plan, consider rolling your account into an individual retirement account (IRA), which will keep your money invested and tax-deferred, says Jeff Gonzales, regional vice president for individual client services at TIAA-CREF. (Read our story here for more on rolling over retirement accounts).
Tapping Your 401(k) Before Retirement
You should only consider tapping your nest egg if you desperately need cash, says Gonzales. Just make sure to proceed with caution. You only have five years to pay the money you withdraw from your 401(k) back. After that, the IRS will tax the distribution at normal levels (as high as 35%) plus invoke a 10% federal penalty.
(For more on tapping your 401(k) before you retire, click here. Read our story for more things you should know about your 401(k)).
4. Retiring Too Early
Few people are actually prepared to retire early, says Greg McBride, senior financial analyst at Bankrate.com.
If you plan to withdraw more than 4% of your retirement assets in the first year, for example, then you better hold off on the retirement party. "That first year sets the stage for how much you're taking in future years, and it's a great indicator of the likelihood that your money is going to last longer than you do," says McBride.
Then, there's the cost of health insurance to consider. If you're younger than 65, you'll need to bridge the gap between when your employer's health coverage ends and Medicare begins. Keep in mind that purchasing private health insurance can cost a hefty sum.
Social Security is another issue. If you start receiving Social Security at age 62, you'll receive reduced benefits. Wait until age 65, and you'll receive full benefits (currently a maximum of $26,120 per person per year, according to the Social Security Administration). Although the rule of thumb is to wait until 65, says Gonzales, it may make more financial sense to receive Social Security checks at a younger age and leave your 401(k) investments to grow tax deferred for a few more years.
(Read our story for more on timing your retirement. And to help you figure out which investments to tap into first, click here.)
5. Not Investing During Retirement
News flash: Just because you retire doesn't mean you stop planning for retirement.
"Retirees need to plan as if they're going to live to age 95," says McBride. "They could have a 25- to 30-year period in retirement and they need to preserve their buying power."
That means avoiding overly-conservative investments early in retirement. If you're retiring at 65, some 45% of your portfolio should be in equities, says McBride. If you work part time during retirement, consider putting some of your earnings in a Roth IRA, which offers tax-free growth and an estate-planning benefit, meaning it gets passed to your beneficiary upon your death.
Here are more tips on how to extend your retirement savings.
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