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The bad things good people do with their 401(k) plans

For better or for worse, 401(k) plans are the foundation of retirement savings for most Americans now. Other than Social Security benefits, 401(k) plans represent the bulk of financial assets available to people after they stop working.

The plans don't come with any guarantees and they don't manage themselves. These tax-advantaged accounts, however, are powerful tools to help people prepare for retirement.

"The 401(k) plan has become the dominant source of retirement savings for most Americans," said Andy Eschtruth, associate director at the Center for Retirement Research at Boston College. "When it comes to private savings, this is it."

Businesswoman putting money into 401K jar at desk
Jamie Grill | Getty Images

In many cases, however, Americans fail to take full advantage of the accounts. Too many people don't enroll in their company's plan, they don't contribute enough when they do, and they make bad decisions along the way that result in much smaller nest eggs at retirement.

Here are the five worst mistakes people make with 401(k) plans.

1. They don't enroll. You can't benefit from a savings plan if you don't participate. Automatic enrollment of employees in 401(k) plans may be the most positive development in the retirement space in the last decade.

It has enabled millennial investors to begin saving for retirement far earlier than their baby boomer parents did. Not all companies will automatically sign you up, however. The contributions are tax-deductible, and they're taken directly from your paycheck ... but you have to enroll in the plan.

"People need to avoid the risks of spending their nest egg too quickly versus denying themselves basic comforts of life." -Andy Eschtruth, associate director at the Center for Retirement Research at Boston College

2. They don't contribute enough. Corporate sponsors who automatically enroll employees in 401(k) plans typically set low contribution levels. Three percent is a common starting point. Contributions of up to $18,000 last year were tax-deductible and retirement experts suggest a level of 10 percent to 15 percent of salary is a more appropriate amount. At a bare minimum, participants should contribute enough to take advantage of employer matching programs.

According to data from the Investment Company Institute, about three-quarters of 401(k) plans, covering 90 percent of Americans, have some form of employer matching policy.

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A typical plan matches 50 percent of employee contributions up to 3 percent of salary, meaning a 6 percent employee contribution level will result in a 9 percent overall contribution. That's a 50 percent return on investment.

"Don't leave money on the table," said Sarah Holden, director of retirement and investor research at ICI. "Take advantage of the employer contribution."

3. They don't manage their account. Are you a do-it-yourself investor, or do you want help drafting an asset-allocation plan and maintaining a diversified portfolio? There are a limited number of fund choices for 401(k) plan participants to invest their money in, but it's crucial that people determine an investment plan and regularly rebalance the portfolio to target allocations.

The simple solution for growing numbers of participants is a target-date fund. More than 70 percent of corporate plans now offer such funds, according to ICI. The funds invest in stocks, bonds and cash in proportions appropriate to an investor's age.

As you get closer to retirement, the portfolio skews more to safer fixed-income investments and away from higher-risk stocks. It's a "set and forget" option for people.

If you prefer managing the portfolio on your own, there are increasingly sophisticated tools to help you do it on most sponsored plans' websites. Calculators help you figure out if you're on track to meet retirement goals and determine what contribution levels you'll need to meet them.

"Go to the plan website and figure out the tools available to you," Holden said. "It's a benefit and people should take advantage of it."

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4. They withdraw funds early. When you take money out of your tax-advantaged 401(k) plan before age 59-and-a-half, you're not only liable for tax on it but you'll also face another 10 percent penalty on the amount.

Such so-called "leakage" is a major issue with 401(k) plans. The power of compounding returns in an investment account only works if the assets remain invested. The Center for Retirement Research at Boston College estimates that 1.5 percent of total assets in the plans are taken out by participants every year, resulting in about 20 percent to 25 percent lower account balances at retirement.

The most common reasons for leakage are cash-outs when people change jobs, withdrawals when they reach 59-and-a-half years old and self-made loans from the plan that aren't paid back.

The loans are the least damaging problem, said Eschtruth at the Center for Retirement Research at Boston College, as participants generally do return the money to the plan to avoid the penalties. "Mostly people pay the loans back," he said. "[The loan option] also has the collateral benefit of encouraging participation in the plans in the first place."

"Don't leave money on the table. Take advantage of the employer contribution." -Sarah Holden, director of retirement and investor research at ICI

5. They don't manage distributions well at retirement. Although 401(k) plan participants can start withdrawing money at age 59-and-a-half, that doesn't mean that they should. With most people now working until age 65 or later, they should continue contributing to their 401(k) and leave the assets to accumulate for retirement.

Distributions from the plans aren't required until you reach age 70-and-a-half. For some people ,it may make sense to draw on 401(k) assets earlier and defer claiming Social Security benefits until 65 or 70 in order to get much higher benefits from the government plan.

There is also the question of what to do with the 401(k) account when you do retire. The options are to leave it in the more regulated and protected 401(k) environment, roll it over into a tax-deferred individual retirement account, buy an annuity with the money or cash it out. Don't do the latter and be careful buying annuities, which can cost a lot of money.

"There's no one right answer to these questions," Eschtruth said. "People need to avoid the risks of spending their nest egg too quickly versus denying themselves basic comforts of life. Our research suggests people are probably better off staying where they are."

— By Andrew Osterland, special to CNBC.com