For an investment vehicle that’s only been around for 29 years, the 401(k) plan certainly has made a difference in American’s financial lives—for good and bad.
The Good Part
Well, 401(k)s, along with the matching contributions from many employers, certainly helped Americans save for retirement for much of the last three decades. From 1988, when the Dow Jones Industrial Average was at 1,833.55, to 2007, when it reached its highest point to date at 13,930.01, life was a cabaret for stock investors. Plenty of regular people, whose 410(k) plans were heavily investing in the stock market, rode that wave to retire as millionaires.
The Bad Part
Well, we can sum that up in four-digits. 2-0-0-8.
It was a bad year for the stock market, and in turn for most 401(k) plans too. How bad? Take a look at how 2008 ranks against some other notorious years in finance. The Dow closed at 8,776.39, down 33.84%. That's about the same percent drop as in 1930 or 1937, which posted 33.77% and 32.82% annual dips, respectively. Of the top ten worst years ever for the Dow, only 1907 (-37.73%) and 1931 (-52.67%) posted greater overall declines.
This brings us all back to 401(k) plans and what first steps one can take to minimize the damage.
Systematically, things haven’t changed all that much in how 401(k) plans are structured. Employees call their own shots, pick their own mutual funds and decide how much they will invest in them. One unfortunate byproduct of the recession, however, is the growing number of companies that are rescinding their company match contributions.
For Help, Start With Your Employer
Still, American workers don’t have to go it alone when handling their 401(k) plans. Virtually every company that offers a 401(k) provides access to the investment companies that distribute and manage them. You can also talk to your company’s human resources department, which should be keeping up with the latest 401(k) plan developments.
Here are some questions you might ask:
1. What benefits am I still getting from a 401(k) plan? The primary benefit is that you’re not taxed currently on the portion of compensation that is placed in the plan, and that’s not going to change because of a lousy stock market. Another benefit of 401(k) plans is that the contributions you make accumulate tax-free until you retire and begin withdrawing funds from the plan. And in retirement, you’ll likely be in a much lower tax bracket than in your wage-earning years.
As noted above, some 401(k) plans offer an employer matching provision in which the employer makes a contribution to the plan equal to a certain percentage of your contribution. Basically it’s free money, and the more you invest, the more your company will match (up to a limit).
2. What does pre-tax mean? When you contribute to your 401(k) account, money gets invested before federal and most state income taxes are calculated. That means you are being taxed on less money than you've actually earned. Your money goes to work for you and continues to grow, earning interest and capital gains on a tax-deferred basis.
3. How much can I contribute every year? In 2007 and 2008, Uncle Sam allowed 401(k) plan participants to contribute up to $15,500 per year. That figure will rise in 2009 to $16,500. If you are age 50 or older by the end of 2008, you are eligible for an additional catch-up contribution of $5,000.
4. What should I do now that the financial markets are getting hammered? It’s not fair, but nobody ever said your 401(k) plan is recession-proof. There are almost no sectors that have escaped the wrath of the financial meltdown. For investment advice, your employee relations specialist will likely turn you over to your investment plan advisor, and they’re likely to tell you to stay the course. There is wisdom in that advice, as markets historically have climbed back after experiencing significant declines. Still, check your funds regularly and keep your eyes open for any fund that continues to experience double-digit declines into the second quarter of 2009. Strive for diversity and check into historically solid sectors, even in bear markets, like utilities, consumer goods, low-end retail stocks and health care stocks.
5. Should I cash out of my 401k plan? Even if your 401(k) plan is dropping like a stone, your investment advisor will be loath to tell you to cash in your proceeds. The tax penalties are too high, and you’ll miss the market rebound when it does happen.
Also, don’t be reluctant to ask about 401(k) plan fees. Most don’t charge commissions and it’s a big red flag if they do. The investment firm that manages your plan is paid a fee based on the percentage of your 401(k) plan's assets. But some companies handle fees differently. So make sure to ask your employee benefits representative how plan and fee expenses are paid, and what your portion of the bill is.
While you may not get an answer to your 401(k) questions right away, you’ll get them eventually. In tough economic times, it’s in your company’s best interest to have employees who know what they’re doing when it comes to managing their 401(k)s.
—To get Uncle Sam’s take on your 401(k) plan, visit the IRS 401(k) guide and look under “Plan Participant.”