7 ways to mess up your 401(k)

The Enron debacle pounded home the point that you do not want your retirement account riding on the same company that provides your job. Yet many people still falsely believe that their company's shares are somehow less risky than a diversified mutual fund.

Some 33% of workers who were offered company stock as an option put more than 20% of their 401(k) money there. That's a dramatic improvement from 1999, but there are still way too many folks overdosing on the company Kool-Aid.

If you must invest in company stock, try to limit the overall investment to 10% of your balance. If your company matches your contributions with its own stock -- as Enron did and as others still do -- invest all of your own money elsewhere.

6. Taking out loans

What seems like a great idea -- Borrow your own money! Pay yourself interest! -- has plenty of traps for the unwary.

The biggest pitfall is the risk you take should you lose your job. Your loan would become due, and, if you couldn't pay it back at once, you'd typically owe income taxes and penalties on the unpaid balance.

The interest rate you pay yourself may be lower than what you would pay most other creditors, but paying yourself interest is no substitute for the real return you would be earning if you had invested those payments instead.

Borrowing from your retirement funds, as nearly one in five workers do, according to EBRI, is often a sign that you're overspending -- particularly if you're using the proceeds to pay off credit card debt. People who use "easy outs" such as 401(k) and home-equity loans to pay off their cards often don't change the underlying behavior that put them in the hole. They just run up their balances again, winding up another day older and deeper in debt.

7. Cashing out

Next to not signing up, cashing out your 401(k) when you leave a job is the dumbest move you can make with a retirement plan.

Yet 45% of the 160,000 401(k) participants Hewitt surveyed in 2005 did just that. The cash-out rates were highest among workers in their 20s. Nearly two-thirds of these workers raided their 401(k) accounts rather than rolling them over to individual retirement accounts or their new employers' plans.

They doubtless think they have years to save for retirement, so why not enjoy the cash now? But the younger you are, the bigger the price you pay for a 401(k) cash-out.

That's because your money, had it been left alone, could have earned tax-deferred returns for decades. That $10,000 you cashed out at 25 could have netted you $200,000 or more in retirement cash, assuming an 8% average annual return and retirement at age 65.

Then there's the tax bite: Combined, the income taxes and penalties you pay typically equal a quarter to nearly half of your early withdrawal.

Your 401(k) money isn't a windfall to be blown on vacations or cars or anything else that will be long forgotten by the time you're 65. This money may be all you have to live on. So treat it with some respect, people.

Liz Pulliam Weston's new book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Updated Dec. 31, 2007

< previous |  1 | 2 |