Like a lot of people, I'm not happy with the way my 401k plan is doing right now. I have not lost a great deal of money like some my friends have. However, I have been wondering if I should pull out of it right now and then maybe later start up the plan again. I have a friend who decided that he was just wasting too much money by investing in the 401k that he stopped contributing to it. The way the economy is going right now I might be better off to keep what I make. Even though I would have to pay taxes on it, at least I would still have some left over. What do you think?
Ruben in Florida
Ruben is not alone. Most everyone with a 401k plan invested in the stock market has suffered some decline in the value of his or her account. So it's only natural to wonder if it's wise to continue contributing to an account that seems to keep losing money. Ruben is really asking three questions. Should he take all of his money out of the account? If not, should he continue to contribute? And, is there some way to improve the performance?
Before we begin, let's make sure that everyone understands that a 401k plan is an account that allows workers to contribute to their own retirement plan. The money that they contribute is deducted from their pay and is not taxed as ordinary income. Many employers match a portion of the employee's contribution. The combination of tax advantages and employer matches allows money to be saved much more rapidly than would otherwise occur.
Now for the first question. Should Ruben close his account? There are exceptions, but for most people who are still working, closing out their 401k plan would be a bad idea.
Withdrawing before you reach age 59 1/2 is expensive. Not only will Ruben have to pay a 10% penalty, but also all pre-tax contributions will be added to his income to be taxed. So, depending on his tax bracket, Ruben could see one quarter or more of his 401k go to the government. A much bigger loss than any likely stock market drop.
The money withdrawn will need to be invested somewhere. For the most part, he'll end up with the same investment vehicles (stocks, bond, CD's, annuities, money funds) as inside the plan. They won't perform any better outside of the 401k than they did before. In fact, they'll grow more slowly since interest, dividends, and capital gains are subject to taxes each year.
So Ruben shouldn't sell out. Should he continue to contribute?
John Bogle was one of the pioneers of the mutual fund industry. In his book Commonsense on Mutual Funds, he studied returns based on the Standard & Poor's Composite Index. From 1927 to 1997, the return over any 10-year period averaged 10.3%. The only negative 10-year return was for the period beginning in 1930 and that produced a -0.8% result.
What's the message for us? That unless you'll need the money soon, it should be worth more if you leave it invested. Time is the best friend an investor or saver has.
A 401k plan is designed to take advantage of time and also of an investment strategy called dollar cost averaging. That's where you invest the same amount of money regularly. You'll actually accumulate more money if stock prices drop periodically. That's true because your regular investment buys more shares when prices are lower. So market dips are a great time to buy.
Selling now would be an emotional response. Professional investors will tell you that emotions are dangerous to your financial well-being.
Also, unless Ruben's a very disciplined person, the money that had been going into the 401k will simply disappear. Adding that money to his take-home pay is an invitation to spend it.
Can Ruben improve the performance of his account? Although the 401k's do limit your investment options, he does have some choices.
When the stock market was roaring, many people liked to brag how well their stock picks were doing. But, that's not the purpose of your 401k plan. Your goal is to gradually increase wealth over a longer time frame so that it's available at your retirement.
His best strategy will include a mixture of investments. Ruben might want to study something called "asset allocation."
It's understandable that Ruben is concerned with his 401k plan. But bailing out is probably the wrong answer.
Gary Foreman is a former financial planner and purchasing manager who currently edits The Dollar Stretcher.com website and newsletters. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report and he's a regular contributor to US News Money and CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+.
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