401k, IRA: How to choose a retirement plan that’s best for you
There are many different retirement savings plans – traditional IRA, Roth IRA, 401k. Here’s how to choose the one that will help you reach your goals.
If you’re an investor who’s made an investment mistake, you’re not alone. Even the Oracle of Omaha himself, Warren Buffett, has made purchases that he regrets in one way or another. In an attempt to generate additional income, a retirement account, send our kids to college, or perhaps fund a vacation home, almost all investors have one thing in common – they want to make more money than what a paycheck brings in.
But sometimes what drives us toward financial success can steer us off the intended path. I’ve highlighted three potential investment mistakes to avoid to help keep investors on the right course, and to build stronger returns while optimizing efficiency – spending less time and money to make more.
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1. Underestimating the upsides of a 401(k)
When people use a 401(k) to invest for retirement, they pay no taxes on the funds they contribute in the year they make those contributions. That’s a big benefit – but it may not be the biggest one. Even better, many employers that offer 401(k)s to their employees will provide matching funds when you contribute to your account – up to a point. The average matching fund ceiling is 3.5% of your annual pay. But some investors make the mistake of not taking full advantage of their employers’ contribution matching, particularly if their company’s match limit is higher than average.
According to a national compensation survey from the Bureau of Labor Statistics, 56% of employers offer a 401(k) plan. Among them, 49% offer no matching funds. Among those employers that do, 41% offer an annual 401(k) contribution match of up to 6% of total wages. But 10% of all employers offer a match of 6% or more. So, if you work for a company with a contribution match, at a minimum you should contribute enough to get the maximum employer match.
So for those in search of a new job, how a potential employer handles their 401(k) plan can be an important factor to consider. As a reference, Southwest Airlines offers up to a 9.3% match, while Duke University provides a 13.2% match for faculty and staff with salaries between $72,000 to $305,000, no matter what the employee contributes. So, if your employer matches 6% and you’re only contributing 1% of your salary, it’s worth it to boost your contribution.
One caution is that once you put money into a 401(k), it’s not supposed to be withdrawn until you’re at least 59 1/2 years old, at which time it will be taxed. And if you pull it out early, you’ll get taxed an additional 10% penalty.
2. Putting dividends to work too late
Dividends stocks offer another way to let someone else’s money make more money for you. Of course, you need to invest in order to own shares of stock. But once you do, you’ll start regularly receiving payments that can help cover your bills. Or, you can reinvest those dividends to boost the number of shares you own. But some investors fail to recognize the important role dividends can play in building a portfolio over the long term.
For example, Coca-Cola (NYSE: KO) is one of the elite Dividend Kings, with a record of increasing its annual dividend for 60 consecutive years. At today’s share prices, its current annual dividend of $1.76 yields about 2.7%.
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An investment of $10,000 in Coca-Cola stock would get you roughly 154 shares as of this writing. That’s $271 per year in passive income, or the equivalent of an extra four shares of stock if you reinvested those payouts. Carry that out over 30 years at a 3.7% average annualized dividend growth rate, plus a 6.5% average share price gain – based on the past 10 years, dating back to the stock’s last split – and the result would be a total of about $19,000 in dividend income by 2052.
There are many companies that offer dividends, and many with yields higher than Coca-Cola’s. It’s also fair to say that the younger an investor is, the more risk they can afford to take on stocks that might have greater share price growth potential without dividends. But this is just one example where putting dividends to use earlier in life can help generate passive income while also shielding an investor from the uncertainties that come with market volatility and an aggressive investment portfolio.
3. Getting distracted by the shiny object
This may be one of the more difficult mistakes to overcome. Dedicated investors spend a fair amount of time and money putting together what they believe are solid portfolios. They’ll make changes to their holdings as new recommendations come along, or as news and earnings reports require them to adjust their investment theses.
But sometimes, hype can suddenly start to boil around a new company, product, or market – think cryptocurrency, the cannabis sector, or meme stocks. These shiny objects can distract investors, dangling in front of them the exciting possibility of becoming a millionaire overnight.
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That’s not to say crypto or legal marijuana won’t pay off for long-term investors – these were just examples. But when the hype dies down, if the bold projections aren’t fulfilled, it’s easy to find oneself sitting on a declining or worthless investment. Meanwhile, if you sold shares from your portfolio to fund this new investment, you could have also missed out on the gains of more reliable companies.
This is where risk/reward needs to be weighed carefully. Getting distracted by the shiny object can be rewarding if you get in early, and if it takes off – two big “ifs.” But when you’ve got a portfolio built up, and are close to retirement age or sending a child to college, you need to protect that investment from pitfalls of volatility. That’s the time not to get distracted by the shiny object.
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