What Should I Do With My 401K?

Should I take my money out of my 401K Plan? Should I change investments in my 401K? Should I continue to make contributions to my 401K? These are a few of the most asked questions of financial advisors today as the values of 401K plans have “vanished” in light of the economic crisis of 2008.

The answers must consider individual situations, but a few basic concepts should always be considered before making decisions to each question.

Should I take my money out of my 401K Plan?

If you take your money out of your plan, it is subject to income taxes. Paying taxes on the decreased values will increase your losses. If you are under 59 ½ you may pay an additional 10% penalty tax. You can avoid the taxation by rolling over to an IRA, but that generally provides no advantage to leaving it in the 401K. Unless the money is immediately needed for another reason, you should not take it out of the plan.

Should I change investments in my 401K?

If you are close to retirement, say within five years, you definitely want to reexamine your asset allocation to be sure you are not too heavily invested in stocks. If you are already retired, you want to be sure that the portion, from which you are taking your retirement income, is in very conservative investments. In most cases, if your investments are diversified, you should consider leaving them as they are. If you move them to a low risk investment now, they will not be able to recover. The more time you have between now and retirement, the longer you can wait for the values to recover.

Should I continue to make contributions to my 401K?

Yes. First, you always want to take advantage of any employer match—it is free money. For example, if the employer matches $.50 for each dollar you contribute, that’s like earning 50% after taxes for each matched dollar. Regardless of economic conditions, you should always contribute up to the amount that the employer will match.

The other reason that you want to contribute is called dollar-cost-averaging. This principle always works to your advantage, but it is especially advantageous when the market is down— like it is now! Here’s how dollar-cost-averaging works. My making monthly contributions, you purchase shares based on their value each month. If the price per share goes up, you get a few less shares that month. If the price goes down, you get a few more shares. Proportionately, you get more additional shares when the price goes down than you give up when the price goes up. Consider the example in the chart below.

Monthly Contribution

Price
per Share

New Shares Purchased

Total Shares

Total Value

Sum Contributed

Gain

$ 100.00

$ 5.00

20.000

20.000

$ 100.00

$ 100.00

0%

$ 100.00

$ 6.00

16.667

36.667

$ 220.00

$ 200.00

10%

$ 100.00

$ 5.00

20.000

56.667

$ 283.33

$ 300.00

-6%

$ 100.00

$ 4.00

25.000

81.667

$ 326.67

$ 400.00

-18%

$ 100.00

$ 5.00

20.000

101.667

$ 508.33

$ 500.00

2%

Average Price per Share

$ 5.00

100

$ 500.00

$100 is contributed each month. The first month the price per share is $5, so 20 shares are purchased. The price goes up the next month to $6 per share. The $100 buys 16.667 shares. The third month, the price is back to $5 and 20 shares are purchased. The next month the price drops to $4 per share, so you receive 25 shares. If the price returns to $5 the next month, 20 more shares are purchased. You now have a total of 101.667 shares worth $5 per share for a total of $508.33. It is easy to see that the average price paid per share was $5. Had all $500 invested been invested at the average price, you would only have had 100 shares worth $500. Systematic purchasing with varying prices allows you to do better than the average.

Let’s continue the prior example, but this time let the prices go really low. This time, the price continues to decline to $1 per share. It would be easy to get discouraged when the price has fallen so low and values so low, but continuing to contribute each month until the market has reversed, provides substantial gains. In this example, dollar-cost-averaging has produced 30% more value than would have been earned buying the stock each month at the average price.

Monthly Contribution

Price
per Share

New Shares Purchased

Total Shares

Total Value

Sum Contributed

Gain

$ 100.00

$ 5.00

20.000

20.000

$ 100.00

$ 100.00

0%

$ 100.00

$ 6.00

16.667

36.667

$ 220.00

$ 200.00

10%

$ 100.00

$ 5.00

20.000

56.667

$ 283.33

$ 300.00

-6%

$ 100.00

$ 4.00

25.000

81.667

$ 326.67

$ 400.00

-18%

$ 100.00

$ 3.00

33.333

115.000

$ 345.00

$ 500.00

-31%

$ 100.00

$ 2.00

50.000

165.000

$ 330.00

$ 600.00

-45%

$ 100.00

$ 1.00

100.000

265.000

$ 265.00

$ 700.00

-62%

$ 100.00

$ 2.00

50.000

315.000

$ 630.00

$ 800.00

-21%

$ 100.00

$ 3.00

33.333

348.333

$ 1,045.00

$ 900.00

16%

$ 100.00

$ 4.00

25.000

373.333

$ 1,493.33

$ 1,000.00

49%

$ 100.00

$ 5.00

20.000

393.333

$ 1,966.67

$ 1,100.00

79%

Average purchase price

$ 3.636

302.5

$ 1,512.50

If we had lost our nerve when the price reached $1 and quit making monthly purchases, we would have only had $1,325 when the market had recovered.

For someone who is a number of years from retirement and has time to let the market recover, dollar-cost-averaging can make this economic crisis a “blessing in disguise.”

Photo credit: m kasahara

About the Author

Maxey Sanderson

Maxey is Impact's President. An insurance specialist with over 35 years of experience in insurance and financial planning, he shares a unique perspective with PlanLab users. Maxey is a graduate of the University of North Carolina at Chapel Hill with a double major in Mathematics and Economics. He became a Chartered Life Underwriter (CLU) in 1975, Fellow Life Management Institute (FLMI) in 1977, and a Chartered Financial Consultant (ChFC) in 1989.

One Response to “ What Should I Do With My 401K? ”

  1. [...] your contributions and taking advantage of the concept of “dollar cost averaging.” (“What Should I Do with My 401K?” October 11, 2008.) This article will consider the investments already in your plan. How can you [...]

Leave a Reply