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Saturday, May 10, 2008

Chismillionaire agrees- stay the course with 401(K)

Don’t lose faith in your 401(k)

For Bernie's Red, a public service post!

Even when markets are headed south, a 401(k) is a great vehicle for retirement savings.

Question: Is it still a good idea to contribute to my 401(k) right now even though the economy isn’t doing too well? -JoAnna Jones, Bossier City, Louisiana

Answer: Let me see, how do I say this to get across just how strongly I feel about this answer? How about: Definitely. No question. Positively. Absolutely. Without a doubt.

Or, to put it another way: Yes.

I can understand why you might feel anxious about contributing to your 401(k) account at a time when the national mood is so gloomy. It’s hard not to let the travails of the moment color your long-term planning.

But the fact is, when you invest money in your 401(k), improving your retirement prospects over the long-term should be your focus.

When you’re contributing to your 401(k) early in your career - say, when you’re in your 20s or 30s - you know that this money is going to be invested at least another 20 to 40 years. So as long as you’re investing in a diversified mix of stock and bond funds, it doesn’t make much sense to get caught up in the short-term ups and downs of the market.

If you’re on the verge of retirement, then clearly you’ve got to give more consideration to what might happen to the value of your account over the next few years. You don’t want to see your 401(k)’s value decimated by market setbacks on the eve of retirement.

But even then the answer isn’t to stop contributing. Indeed, the money you invest in the last few years before you call it a career may very well turn out to be the funds that will sustain you in the later stages of a retirement that could last 30 or more years. Rather, the way to protect your nest egg as you approach retirement is to gradually shift more of your 401(k) portfolio from stocks to bonds.

I realize, however, that concern about the short-term can often blind us to long-term considerations. So I’d like to offer three more immediate reasons why you shouldn’t abandon your 401(k) now.

You’ll be giving up a tax break, and possibly free money. One of the nice little advantages of participating in a 401(k) is that you get to invest pre-tax dollars, which lowers your current tax bill. What’s more, the investment gains on your contributions - as well as the gains on your gains - grow without the drag of taxes. Yes, you do eventually pay tax on this money at withdrawal. But years of tax-deferred compounding allows you build a bigger nest egg than you could with taxable accounts alone, which in turn allows you to live a more comfy retirement.

And if your 401(k) plan is among the majority that provides employer matching contributions - typically 50 cents for every dollar you contribute up to 6% of salary - then bowing out of your plan now is like giving up free money.

Walking away from these and many other benefits of 401(k)s just makes no sense, even if the economic outlook at the moment appears tenuous.

You may be foregoing attractive returns. There are no guarantees when it comes to the financial markets. But there’s a good chance that the money you invest in your 401(k) when the markets are struggling will give you some of the highest returns you’ll earn over the long run.

This is a somewhat counterintuitive concept. People tend to feel most comfortable about investing after the markets have been on a roll and have racked up big gains. But the exuberance that naturally occurs during bull markets eventually leads investors to bid up share prices to blimpish levels. That diminishes the potential for future gains much the same way that overpaying for a house does.

When things are looking more bleak and investors are wary, on the other hand, share prices are generally lower relative to companies’ long-term earnings power. That translates to a greater potential for higher long-term returns than when things are going swimmingly.

I’m not suggesting that 401(k) investors should try to time their contributions to any particular market outlook. That would be foolish. But at times like today when pessimism is pervasive, it’s not a bad idea to remind yourself that the money you contribute when your fellow investors are most skittish often ends up racking up higher returns.

You might not resume contributing if you stop now. Another nice advantage of contributing to a 401(k) is that it forces you to live a bit below your means. Your contribution comes out of your paycheck before you get your hands on it, so your spending naturally conforms to what’s left - that is, your income after you’ve allowed for saving.

If you suspend your 401(k) contributions, however, you’ll be giving up this little psychological advantage. Your paycheck will be larger, thus freeing up more money for you to spend. Even if you plan on resuming your contributions when the economy improves, doing so may be more difficult than you think, especially after you’ve gotten used to having that extra money to throw around. It’s always harder to scale back your lifestyle than it is to ratchet it up. So I think there’s a real danger that what you intend as a temporary hiatus from your 401(k) could turn into a long-term absence that seriously impairs your retirement prospects.

Bottom line: It’s challenge enough to create a retirement nest egg these days even if you contribute faithfully to your 401(k) throughout your career. Start moving in and out of your plan based on how you feel about the economy and that challenge could become a mission impossible.

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