If you have made contributions to a 401(k) through your employer, it's natural to be concerned about the plan's performance. Like all investments, there are risks involved with setting aside funds for the future. While many 401(k) plans are designed to safeguard against substantial losses, it's not unheard of to see an account balance drop occasionally.
A 401(k) loss can occur if you:
-- Cash out your investments during a downturn.
-- Are heavily invested in company stock.
-- Are unable to pay back a 401(k) loan.
-- Quit your job before you own the company match.
Growing 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.
Switching Investments in a 401(k) to Cash
If you monitor your account balance periodically, you might notice some fluctuations, especially as the economy responds to changes. "People get scared when they see account balances start to go down during market downturns," says Clayton Quamme, a certified financial planner at AP Wealth Management in Augusta, Georgia. "They start to panic and move their money into cash for safety."
While it may seem like you're being safe by pulling the funds from an investment and holding them as cash, the action could create a financial setback. "When you sell during a downturn, you are making a temporary loss permanent," Quamme says. "If you stay invested, your account balance will go up as the market recovers."
Carrying Too Much Company Stock
Some companies offer a direct investment program, which allows certain employees to buy company stock within the 401(k). The arrangements might include a company match or other incentives designed to encourage employees to purchase the stock. "These perks can be a great way to utilize all of your company benefits," says Jon Lawton, a managing partner and certified financial planner at OpenAir Advisers in the Dallas-Fort Worth area.
At the same time, it's wise to look at your overall financial plan and carefully decide how much company stock you would prefer to have. "A general rule is to never have more than 5% of any one stock inside a retirement plan for someone approaching retirement," Lawton says. If you have more, you could run the risk of higher losses. For instance, 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 have company specific risk as well," Lawton says. If the company performs poorly or goes bankrupt, you could bear a heavy loss. "Owning company stock as a portion of your total retirement plan can be a valuable and profitable part of your portfolio if it aligns with your overall risk," Lawton says.
Taking Out a 401(k) Loan
If you need access to your 401(k) balance before retirement, you could take an early withdrawal or a 401(k) loan. However, 401(k) withdrawals before age 59 1/2 generally trigger a 10% early withdrawal penalty and income tax. Alternatively, you could take a loan from your 401(k) account, which doesn't lead to penalties or taxes if you pay the money back plus interest.
However, a 401(k) loan could create some financial risk, especially if you leave your job before you repay the loan. "It's likely you will need to pay the loan back immediately," says Katharine Earhart, partner and co-founder of Fairlight Advisors in San Francisco. If you are unable to pay back the loan, your former employer might consider the loan a distribution. For those under age 59 1/2, the balance of the loan will be subject to the early withdrawal penalty and taxes, plus those funds won't have the chance to earn interest and grow in the coming years.
Leaving Before You Are Fully Vested
Some companies have certain requirements that need to be met before you are entitled to keep all of the 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 belong to you after you've worked for a certain amount of time. "Most companies require you to stay for 3, 5, even 7 years before you get the company match," Lawton says. If you leave before you are fully vested in your 401(k), you might lose out on the match.
Avoid Losses Through Risk Management
To steer clear of emotionally packed decisions that could lead to 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 divided into several types of investments. "If you are in a well diversified portfolio of equities and fixed income, then your risk is spread among different asset classes," Earhart says. Having a large portion of your investments in equities can increase risk, especially if you are close to retirement age.
Some companies automatically enroll employees in a 401(k) when they join the workplace. The workers are then auto-assigned a portfolio based on their age and target retirement date. If this happens to you, it can still be beneficial to read through the investments and decide what amount of risk is comfortable for you. "The best strategy is to pick an allocation based on your goals and emotional ability to stay invested," Quamme says. "Then stick to it."