If you’ve contributed to a 401 (k) through your employer, it’s natural to worry about the plan’s performance. Like all investments, setting aside funds for the future comes with risk. While many 401 (k) plans are designed to guard against substantial losses, it is not uncommon to see an account balance drop occasionally.
A 401 (k) loss can occur if you:
– Cash in on your investments during a downturn.
– Are heavily invested in the shares of the company.
– Are unable to repay a 401 (k) loan.
– Quit your job before you own the business game.
Increasing your 401 (k) balance involves being aware of the risks and taking steps to mitigate them. Here’s a look at how money can be lost in a 401 (k) and what you can do to avoid setbacks.[Read: How Much Should You Contribute to a 401(k)?]
Converting investments in a 401 (k) to cash
If you periodically monitor your account balance, you may notice some fluctuations, especially as the economy reacts to changes. “People get scared when they see their account balances start to drop during market downturns,” says Clayton Quamme, certified financial planner with AP Wealth Management in Augusta, Georgia. “They start to panic and transfer their money to cash for added security.”
While it may seem like you are safe withdrawing funds from an investment and keeping them in cash, the action could create a financial setback. “When you sell during a downturn, you make a permanent temporary loss,” Quamme says. “If you stay invested, your account balance will increase as the market recovers.”
Having too many company shares
Some companies offer a direct investment program, which allows certain employees to purchase company stock under 401 (k). The arrangements could include a company match or other incentives designed to encourage employees to buy the shares. “These benefits can be a great way to utilize all the benefits of your business,” says Jon Lawton, Managing Partner and Certified Financial Planner at OpenAir Advisers in the Dallas-Fort Worth area.
At the same time, it is wise to review your overall financial plan and carefully decide how many company shares you would prefer to have. “A general rule of thumb is never to have more than 5% of a share in a pension plan for someone nearing retirement,” Lawton said. If you have more, you could run the risk of larger losses. For example, let’s say you have 50%, 80% or even 100% of the 401 (k) invested in company stock. “Not only do you have market risk, but you now also have company specific risk,” Lawton said. If the business performs poorly or goes bankrupt, you could suffer a heavy loss. “Owning company stock as part of your total retirement plan can be a valuable and profitable part of your portfolio if it matches your overall risk,” Lawton says.[Read: What Is the Average 401(k) Return?]
Take out a 401 (k) loan
If you need to access your 401 (k) balance before retirement, you can make an early withdrawal or a 401 (k) loan. However, 401 (k) withdrawals before age 59 1/2 typically trigger a 10% early withdrawal penalty and income tax. Alternatively, you can take out a loan from your 401 (k) account, which incurs no penalties or taxes if you pay back the money plus interest.
However, a 401 (k) loan could create some financial risk, especially if you quit your job before paying off the loan. “It’s likely that you will have to repay the loan immediately,” says Katharine Earhart, partner and co-founder of Fairlight Advisors in San Francisco. If you are unable to repay the loan, your former employer may view the loan as a distribution. For people under the age of 59 1/2, the loan balance will be subject to the early withdrawal penalty and taxes, moreover these funds will not have the chance to earn interest and grow in the years to come. .
Leave before being fully invested
Some companies have certain requirements that must be met before you are eligible to hold any funds in your 401 (k) plan. The contributions you make are always 100% yours. If the company provides a 401 (k) match, that amount might only be yours after you’ve worked for a while. “Most companies require you to stay 3, 5, or even 7 years before you get the company match,” Lawton says. If you leave before you are fully invested in your 401 (k), you risk losing the game.[See: 9 Ways to Avoid the 401(k) Early Withdrawal Penalty and Other Fees.]
Avoid losses through risk management
To avoid emotionally charged decisions that could result in a loss, it can be helpful to have an investment plan in place. This often involves a discussion with a financial advisor and a review of your portfolio to see that your contributions are broken down into several types of investments. “If you’re in a well-diversified portfolio of equities and fixed income, then your risk is spread across different asset classes,” Earhart explains. Having a large chunk of your investments in stocks can increase risk, especially if you are near retirement age.
Some companies automatically enroll their employees in a 401 (k) when they join the workplace. Workers are then automatically assigned a portfolio based on their age and target retirement date. If this happens to you, it can always be beneficial to read the investments and decide on the level of risk that is right for you. “The best strategy is to choose an allocation based on your goals and your emotional ability to stay invested,” Quamme said. “So stick to it. “