By Kelli B. Grant,
Senior Consumer Reporter, SmartMoney.com
Preparing for retirement is no easy feat in the slumping economy.
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 a comfortable retirement, here are five all-too-common 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 2008.
Understandably, most young adults are more concerned about paying down student loans and making ends meet -- not to mention nervous about investing amid recent market swings. But neglecting to set something aside for retirement during these early years is a big 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.
For more on the benefits of starting your 401(k) early, see our guides here and here.
2. Failure to Diversify
Yes, the economy -- and the markets -- are in a slump. But it doesn't follow that you should be extremely conservative in your investments, warns Benjamin Tobias, a certified financial planner based in Plantation, Fla. To get the most out of your 401(k), make sure that you have a good mix of stocks and bonds.
Younger investors with plenty of years left before retirement should take a riskier approach with a larger percentage of their money (typically about 80% of their portfolio) in high-growth stocks, says Tobias. Investors in their 50s should take a slightly more conservative approach using more cash and bonds, but still keep roughly 60% in equities. (For more tips, click here.)
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 picking a target-date fund, read our story.
3. Mismanaging Your 401(k)
With a 401(k) you're the one calling the shots, says Pamela Hess, director of retirement research at Hewitt Associates. Here's how to be a good custodian in the years before you retire:
Get the company match
Often, employers pledge to match an employee's contribution up to a certain percentage of their salary. The usual match: 50 cents for every dollar up to 6% of your pay, according to Hewitt Associates. If you don't contribute enough to get the full match, you're passing up free money. (That's a mistake roughly 30% of workers make, says Hess.)
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. (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, warns Hess. "It needs to be a very last resort," she says. "That's un-repairable damage." 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
Even in a good market, few people are actually prepared to retire early, says Hess. Given the poor economy, it's an especially perilous course of action. "Most people are going to have to work longer to make up for what happened [to their portfolios]," she says.
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 Hess.
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 66, and you'll receive full benefits (currently a maximum of $27,876 per person per year, according to the Social Security Administration). Although the rule of thumb is to wait until full retirement age, 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.
"Even if you're 60 years old, you could still have a 30-year time horizon to invest," says Greg McBride, senior financial analyst at Bankrate.com. "You need to preserve that buying power."
That means avoiding overly conservative investments early in retirement, which hinders your investments' ability to recover from recent market losses and outpace inflation. If you're retiring at 65, at least 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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