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Costly Mistakes with 401(k)s

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This is a big one. The IRS would love for you to take every penny out of your 401(k) when you change jobs for one very good reason: more tax revenue.

Costly mistakes with 401(k)s are common but avoidable if you pay attention and get proper advice.

Making sure that you handle your 401(k)s correctly is not as easy as letting payments be automatically deducted from your wages. Here’s a look at commonly made mistakes, detailed in the article aptly named “More common 401(k) mistakes—and their consequences” from tucson.com.

Investing after-tax dollars before maxing out pretax opportunities. Some plans let you choose to contribute to your 401(k) on a pre-tax or after-tax basis or both. The problem happens when the forms provide these choices without giving an explanation of the different choices. Generally speaking, you always want to lower your W-2 earnings by contributing pretax dollars first. Your W-2 won’t include the money you put in a 401(k) or other retirement savings vehicle.

Cashing out a 401(k) when you change jobs. This is one of the big and bad mistakes with 401(k)s. The IRS loves when you do this because the withdrawal is taxable income that would otherwise sit in a 401(k) for years, possibly decades. One survey showed that as many as 28% of people between the ages of 35-65 did not know that some of their retirement distribution choices would trigger tax liabilities and penalties.

A better option: leave the 401(k) with your old employer, move it to your new employer’s plan if that is an option, or set up a rollover IRA with a bank or investment firm to transfer the 401(k). Do this very carefully: you are rolling over the money, not cashing it out. Don’t use the money when you move it—this is your best savings option for retirement.

Borrowing from the plan to pay for a big-ticket purchase. Yes, there may be a loan feature in your 401(k) plan. However, while this may be a blessing in an emergency, it is likely to be one of the most expensive loans you ever take. There are strict rules about paying back 401(k) loans and running afoul of them could create more problems. Read the fine print before borrowing against your retirement fund. Remember, you are borrowing against your future.

Defaulting on a 401(k) loan. Don’t give yourself a loan from your 401(k) unless you understand all of the rules and penalties. Most 401(k) loans must be paid back within five years unless the loan is used to purchase a primary residence. However, this is supposed to be a retirement savings account, not a house fund. You should also find out what happens if you quit or lose your job while the loan is outstanding. The balance of your 401(k) account is often used to pay for the outstanding loan, and you’ll be responsible for paying taxes on the withdrawal PLUS a tax penalty for early withdrawal from the 401(k).

Thinking you’ve got plenty of time before retirement. The sooner you start saving for retirement, like when you receive your first paycheck, the better. Pay your future self first. You can always get a loan for a home, a car, or your children’s college education, but there’s no such thing as a retirement loan.

Failing to have proper beneficiary designations. Most people designate a primary beneficiary. Many fail to designate secondary beneficiaries. If no one is surviving, the plan goes to your estate, with bad income tax results. Naming a minor child instead of a trust for that child means someone must be appointed guardian through a court proceeding, and then when child turns 18, he or she will get uncontrolled use of the funds.

Consulting with a financial advisors and estate planning attorney, creating or updating your planning, and coordinating that with your beneficiary designations will help your family avoid costly mistakes with 401(k)s.

Reference: tucson.com (Nov. 15, 2019) “More common 401(k) mistakes—and their consequences”