If you have contributed to a 401(k) through your employer, it’s normal to be concerned about the plan’s performance. Like all investments, there are risks associated with setting aside funds for the future. While many 401(k) plans are designed to protect against significant losses, it’s not unheard of to see an account balance drop from time to time.
A loss of 401(k) can occur if you:
— Cash in on your investments during a recession.
— Are heavily invested in company stock.
— Are unable to repay a 401(k) loan.
— Quit your job before you own the company match.
To grow your 401(k) balance, you need to be aware of the risks and take steps to mitigate them. Here’s how to lose money in a 401(k) and what you can do to avoid setbacks.
Switching Investments in a 401(k) to Cash
If you check your account balance regularly, you may notice some fluctuations, especially as the economy reacts to changes. “People get scared when they see account balances start to fall during market declines,” said Clayton Quamme, certified financial planner at AP Wealth Management in Augusta, Georgia. “They start to panic and turn their money into cash for safety.”
While it may seem like you are safe by taking the money out of an investment and holding them as cash, the action could cause a financial setback. “If you sell during a recession, you make a temporary loss permanent,” Quamme says. “If you stay invested, your account balance will increase as the market recovers.”
Transporting too much company inventory
Some companies offer a direct investment program, which allows certain employees to purchase company stock within 401(k). The arrangements may include a company match or other incentives designed to encourage employees to purchase the shares. “These benefits can be a great way to leverage all of your business benefits,” said Jon Lawton, a managing partner and certified financial planner at OpenAir Advisers in the Dallas-Fort Worth area.
At the same time, it is wise to look at your overall financial plan and carefully decide how many company shares you would like to own. “A general rule is to never have more than 5% of a stake in a retirement plan for someone nearing retirement,” Lawton says. If you have more, you run the risk of higher losses. For example, 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,” Lawton says. If the company underperforms or goes bankrupt, you can bear a heavy loss. “Owning company stock as part of your overall 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 you retire, you can take out an early withdrawal or a 401(k) loan. However, 401(k) withdrawals before age 59 1/2 generally incur a 10% early withdrawal penalty and income tax penalty. Alternatively, you can take out a loan from your 401(k) account, which will not incur any penalties or taxes if you repay the money plus interest.
However, a 401(k) loan may involve some financial risk, especially if you leave your job before you have repaid the loan. “It’s likely that you’ll have to repay the loan immediately,” said Katharine Earhart, partner and co-founder of Fairlight Advisors in San Francisco. If you are unable to repay the loan, your former employer may treat the loan as a benefit. For those under 59 1/2 years of age, the loan balance is subject to the early withdrawal penalty and taxes, plus those funds won’t have a chance to earn interest and grow for years to come.
Leaving before you fully vest
Some companies have certain requirements that must be met before you are entitled to keep all of the money in your 401(k) plan. The contributions you make are always 100% yours. If the company has a 401(k) match, that amount can only be yours after you have worked for a certain period of time. “Most companies require you to stay for 3, 5, even 7 years before you get the company match,” says Lawton. If you leave before you are complete rest with your 401(k), you could lose the match.
Prevent losses through risk management
To avoid emotionally packed decisions that could lead to loss, it can be helpful to have an investment plan in place. This often includes a meeting with a financial advisor and an assessment of your portfolio to see that your contributions are broken down into different types of investments. “If you’re in a well-diversified portfolio of stocks and fixed income, your risk is spread across different asset classes,” Earhart says. Much of your investment in stocks can increase risk, especially if you are close to retirement age.
Some companies auto-enroll employees in a 401(k) when they come to the workplace. The employees are then automatically assigned a portfolio based on their age and intended retirement date. If this happens to you, it can still be useful to read through the investments and decide what risk is comfortable for you. “The best strategy is to choose an allocation based on your goals and emotional ability to stay invested,” Quamme says. “Then stick to it.”