Why you should keep your money in your 401k plan
By glblguy
Photo by: nbreazeale
We had some friends over for dinner the other night. We try to get together with them about once a month. Pretty much every time they come over, Mike either asks me questions about his 401k or brings over some 401k paper work he needs some help with. Mike is a really hard worker who builds patios and decks for a national outdoor room company. He knows a tremendous amount about building houses, rooms, patios, decks, and fixing cars but he knows little to nothing about finances or investing. Mike, his wife and their three girls have been friends of ours for a long time, and I don’t mind helping him out at all.
Over dinner, he told me about a co-worker of his that recently pulled out all of his 401k plan money, and the co-worker was advising Mike to do the same. I asked him why the co-worker was pulling his money out, and Mike explained that his co-worker had noticed that over the past few months he was losing money. To keep from losing money, he pulled it out of the 401k plan and placed it into a savings account. He asked what I thought. My immediate reply was “No!” and I explained to him why this was such a bad idea:
A 401k plan is a long term investment
Most 401k plans offer mutual funds as the primary investment tools. Mutual funds are a long term investment, and most financial experts recommend keeping your money in them for more than 10 years at the minimum. Mutual funds consist of company stocks, and based on the market the values of the fund over any one period will be high and low depending on how the market is doing. Right now, the market is down, and thus most everyone’s investments, mutual funds, and 401ks are taking a beating. I know mine is.
The good news is that over the history of the market, stocks and thus mutual funds return on average 10-15%. In order to receive the benefits you have to hang in there and keep putting your money in even when the market is down.
Another point is as you contribute money, you are buying new funds. When the market is down, you are buying those funds at a lower price and when the market does go back up you will earn more. Remember: buy low, sell high.
There’s a penalty for pulling out your money
When you take an early withdrawal of your 401k money, there is a mandatory IRS early withdrawal penalty of 10%. Additionally, your 401k money will be treated as taxable income. 20% will automatically be pulled out, and the remainder will is required to be listed as income when you file your federal and state income taxes. Depending on the amount in your 401k, this can be a considerable some of money and can cause you to have to pay a larger than expected amount of income tax.
Chances are you’ll spend the money
As with any large windfall of cash, most people want to spend either some or all of it. While his friend said he moved it into a savings account, I don’t believe that he truly moved it all, nor do I believe it will stay there. I know from past experience when I received a large windfall of money, we spent some portion of it on things we wanted. Examples include a new truck, camper, wide screen HDTV, computers, etc.
Leaving money on the table
Mike’s company contributes 50% for every dollar he contributes up to 6%. I explained to Mike that this is “free” money and promises far greater returns than any savings account could offer. My employer contributes dollar for dollar, so my free money is even more. Just because your investments are doing poorly right now in your 401k plan, don’t forget the employer match if you have one. Over time, this can cause considerable growth for your retirement fund.
In the end
Fortunately, Mike took my advice and is both keeping his money in his 401k plan and continuing to fund it. I was really glad he made this decision and it will pay off for him in the long run. He was anxious to talk to his friend and tell him how crazy he had been for pulling his money out. While I feel bad his friend made such a bad decision, I do home he learns from the experience.
Keeping your retirement money in a 401k plan provides proven returns, reduced income taxes, and incentive via penalties and tax hits to keep your money in it and not use it unwisely. Contributing to a 401k and/or IRA program can change your financial life and quickly start your path towards being wealthy. If you aren’t contributing to a 401k or IRA program, start today.
I am not an investment guru by any means, but would highly recommend you read The Dough Roller and Moolanomy whose blogs focus more on investing and retirement. Oh, and while I’m thinking about it, if you do have a 401k, don’t take out 401k loans. I wrote about why taking out 401k loans is a bad idea a while back.
Did I miss anything? Can you think of other reasons pulling your money out of your 401k is such a bad idea? Add a comment!
January 17th, 2008 at 12:10 pm
Looks like you got it pretty well covered. That’s real unfortunate what Mike’s friend did.
Thank you for the endorsement!
January 17th, 2008 at 12:18 pm
Thanks for the article. Someone at work was telling me just last week that she was considering lowering her 401k contributions (our company matches each dollar up to $95) because she was losing money this quarter. It’s nice to know that if you wait it out, you will see the return.
January 17th, 2008 at 12:55 pm
Just a thought about the down market. A long time ago, a broker put it to me this way: “When the market is down, stocks are on sale.”
January 17th, 2008 at 1:05 pm
@KMunoz – Well, of course with the stock market you never can predict, but if you look back in history 30 years or so, the market has consistantly performed at 10 – 15% return. Over 30 years there were many ups and downs. I’d say 30 years is a pretty good track record to project future returns on. Just stay the course!
@karen w – Excellent advice.
January 17th, 2008 at 2:29 pm
Actually, I would LOVE to be able to take my money out of my 401(k), I’d roll it directly over to an IRA where I have more control of it AND have lower costs. .25% of my money is taken by the fund management company. An in service distribution, not many people have that option.
Also, don’t forget most 401(k)s have a guaranteed or a money market option that is very easy to move all your cash to. Not that I advocate that. However, it’s still going to cash and not taking your money out.
January 17th, 2008 at 2:52 pm
Mike’s friend should not have pulled his 401k funds out. The penalty alone makes it a terrible idea. I think he forgets that the 401k is a long term investment not a short term trading account.
January 17th, 2008 at 3:18 pm
@Justin – I agree, IRA does give you more control and in some cases you ditch the management company fee, but you walk away from the employer match, which for me is a 100% return ($1 for $1). So that wouldn’t be a good option for me…I’d be leaving a lot of money on the table. Good point on the money market option…I also agree it’s a bad move….guess I believe it so bad I forgot about it ;-)
@MBB – Nope, but he did so not understanding the ramifications nor having a good understanding of mutual funds or retirement accounts. It’s unfortunate that company doesn’t educate better on their 401k plan. I think he thought if he put his money in there it would just grow at 15% until he pulled it out.
January 17th, 2008 at 3:21 pm
Re: losing the match – Nonono. That comes too, and then keep distributing the whole bunch o money every 12 months or whatever to an IRA!
January 17th, 2008 at 3:44 pm
Oh, I see what you are saying….but you can only do that WITH in-service distribution. Gotcha, misunderstood. Yeah, we don’t have it either…that would be nice, best of both worlds then.
January 17th, 2008 at 3:46 pm
I’m still wondering how his coworker removed his 401(k) monies, as as far as I am aware, it’s really hard to withdraw the cash from a plan while you still work there.
January 17th, 2008 at 3:52 pm
@Justin – I was wondering the same thing, but seems (from googling) that there are some company programs that let you do that. I know mine doesn’t.
January 17th, 2008 at 3:56 pm
I have a small difference of opinion concerning the good rule on not taking out a 401K loan. I believe there are some viable scenarios where doing just that is justified.
Typically, you will make between 3 and 10 percent return on your 401K account each year. If you are in serious debt and have say 5000 dollars in delinquent credit card debt sitting at 33 percent interest a loan may be necessary.
You instantly have your daily worries about the debt relieved along with the stoppage of hefty late payment penalties. This kind of bad debt may not equate to the amount of compound interest lost in 30 years but getting rid of it gives you a new start and stops the bleeding.
You also pay it back using dollar cost averaging, though after tax and with no employer match, and after five years have it paid back.
Medical emergency costs could be another reason but other then critical events such as the above your advice is wise and sound.
I keep seeing the DOW drop 200 points and I grin. I’m getting tons of stock purchased at a bargain rate right now. I’ve got 30 years left what do I care?
January 17th, 2008 at 4:41 pm
It’s a great shame that more people aren’t interested in learning the bare minimum about investing. I find myself worrying about people like Mike’s friend who don’t appreciate the implications of their ill-informed decision. Note to self: must write about sensible investing more.
January 17th, 2008 at 4:55 pm
I think Pinyo manages to get the first comment to every blog post in the known universe! GLBL, that’s a perfect summary. Even my mom is tempted to take out her retirement from time to time (she’s older than 59 1/2, but still working), and I keep telling her to wait. Your friend made a choice he will in later years look back on with relief.
January 17th, 2008 at 6:13 pm
@Thanks Pinyo and you’re welcome!
@plonkee – I agree, was thinking the same thing when I wrote this article.
@Cheapster Bob – I would agree, there is an exception to every rule, but your 401k money should only be pulled out in an extreme situation. If your tax bracket is 30%, it’s get getting a loan with a 40% interest rate (30% tax+10% fee). Of course if it’s a decision of can’t put food on the table vs. doing a withdrawal on your 401k, than I would agree.
@DR – Thanks!
January 17th, 2008 at 8:01 pm
Good post – the key to equity investing is to hold on the for long term.
Mike
January 17th, 2008 at 8:35 pm
Thanks Mike!
January 17th, 2008 at 9:07 pm
I saw this earlier today but had to come back and comment. I wrote earlier today about my 401k and was surprised to see an article about the same thing. A bit different though-I’m not thinking of cashing out or getting a loan from my 401k.
You confirmed some things though-it’s going to be a bumpy year but we should all hang tight.
January 17th, 2008 at 9:40 pm
@Erin – Yes, read your article during lunch time. Mine looks similar to yours, and saw on the news today that we had another large drop today. It will return in time…we just have to stay the course!
January 17th, 2008 at 10:38 pm
Hey Gather. First time here and like the site a lot.
Nice post. Kind of shocking to hear people taking their money out of 401k’s. When markets get as topsy turvy as these, people make made decisions.
I’m sure if the numbers were available for people that pulled out of 401k’s, you’d see a jump in distributions for December and now January.
These turbulent times are the ones where having a trusted adviser or a knowledgeable friend (in your case) can save people from themselves, and a lot of money in the long run.
Look forward to visiting regularly going forward.
January 17th, 2008 at 10:44 pm
Great minds think alike eh? I wrote my article and then went to read blogs in my RSS reader. I had to click over to your site when I saw what you were talking about.
I wonder how many other people are starting to wonder the same thing about their 401k’s? It’s scary to see the numbers drop. I guess that shows I’m still a newbie to this all.
Oh-and my jaw dropped when I saw that the DOW was down 300+ today. yikes. I think I will listen to Plonkee and not check my account for awhile (which is SO hard!)
January 18th, 2008 at 7:35 am
I agree with the sentiment expressed here. However, there is one thing I can’t quite wrap my brain around. Just BEFORE the market started gyrating in August (was it?) I xferred all my money within my 401K from stocks to cash. During that time, obviously my money has grown, while the market continues to slip.
I fully understand the concept of dollar cost averaging, and “stocks on sale.” However, can someone explain to me why I don’t just keep my money in cash until either economic forecasts improve, or the market starts a consistent climb? If I monitor the market closely, (which I did to pull my money out before the drop), couldn’t I take all the interest I’ve been earning, along with the principal, and jump back on the elevator as it goes back up (by xferring back to stocks)? Wouldn’t I be coming out ahead?
I’m sorry if this is worded poorly, but I can’t get past this justification I’ve created in my own mind. Am I missing something?
January 18th, 2008 at 9:24 am
@Jason L: Chances you will know when to get back on are pretty low. You can easily miss the best days of an increase and you’re screwed. You should look up what Market Timing is if you want to educate yourself on it.
January 18th, 2008 at 10:44 am
@Ciaran – Thank you! Welcome to the site!
@Erin – I’m guessing a large number of people are. Would suspect the less familiar you are with investing the more likely you are to want to bail. I still look, but don’t sweat it. It’s the nature of the beast.
@Jason – Well, maybe…but maybe not. Right now, your money is buying stocks at low prices. Once the market gains, the stock values will go up (if history proves accurate). Chances are, you’ll gain more than the 3 or 4% you’re getting from the cash/money market fund. Now, stocks are risky and unpredictable so the right decision to make is subjective and very individual based on your level of risk.
The Market has had a return that averages 10-15% over the past 30-years. In that 30 years there have been ups and downs, we’re just in a down right now. Based on history, leaving your money will net you a 10-15% return which is far greater than the 3-4% you’re getting now.
Justin is also right, by the time you realize the market is going up, most likely it will be too late to really take advantage of the growth. I prefer to trust the professionals managing my mutual funds…they are far more educated than I on the subject.
Hope this helps. I’d recommend seeing a certified financial planner if you really want the details and some professional advice. I’m just sharing my perspective and thoughts on it.
January 18th, 2008 at 11:16 am
@glblguy: You use managed funds???
January 18th, 2008 at 11:24 am
@Justin – Might expose my investing ignorance here…but aren’t mutual funds managed? I think maybe you are talking about a fund that has a dedicated manager vs. something like an Index fund right? In either case, they have fees…managed are just way higher
I had to look to be sure, but most of my 401k mutual funds are index, but a few are managed. I decide purely based on the return. We have a limited selection of funds and to be honest, none of them are great.
Now, if I was buying funds outside of my 401k, I would only go with index funds and one’s with no-load index fund. Read on the motley fool the other day though that even many of the popular index funds are charging higher rates due to the popularity.
January 18th, 2008 at 11:30 am
Well, sort of. Most index funds from what I can gather are actually “managed” by a computer that keeps them in line with their index. So there’s very little decision making done by professionals, if any.
Inside my 401(k) I am pushing all my money into the one Vanguard index fund in there, which is the 500 index. The 401(k) company is charging me .25% on top of the embedded expense ratio of .05%.
Outside I am in a Vanguard Roth IRA with money in other indexes to bring my asset allocation to where I want it to be.
The most popular index funds I run across are the Vanguard family of indexes as well as the few Fidelity Spartan series. As far as I am aware the costs haven’t increased on these and have gone down slightly.
January 18th, 2008 at 12:07 pm
Ok, we’re saying the same thing. You’re right, the fee is dependent on the owner of the fund. That fund has an expense ratio of .07% currently, so there is a fee…just real low. Unfortunately, Vanguard funds aren’t an option for me with my 401k…otherwise I’d have all my funds there too.
Based on your .05% and the look up I did, it has gone up…but by a very small amount.
January 18th, 2008 at 12:16 pm
Index funds track a specific index. There’s no active management, changes are made when there is a change in the underlying index.
Often you’ll hear on CNBC, XYZ is being added to the S&P while ABC is being removed. The index fund will make the adjustment to reflect the changes, that’s the extent of it.
Inside a company sponsored 401k choosing low cost index funds is an excellent choice, your best choice actually, when it comes to managing internal costs.
Outside of that, in an IRA for instance, you should really look to ETF’s as an alternative. ETF’s are passive investments (tracking an underlying index just like the index funds) with expense ratios in line with the most affordable index funds. ETF’s give you a little more flexibility than index funds IMO.
January 18th, 2008 at 12:36 pm
Thanks Ciaran – Way out of my comfort zone on all of this. Plan to blog more on investing once I’m out of debt :-)
January 18th, 2008 at 3:14 pm
I just added to my portfolio yesterday in the midst of the doom and gloom reports coming from the panic media.
I opened up a target date Roth fund set for a retirement year of 2035 over at Troweprice.com. It is a mutual fund of mutual funds providing diversity on top of diversity and adjusts automatically each year.
One less worry for me and if you auto-pay fifty bucks a month they waive the minimum (2500.)
Since I’ve already maxed the 401, am filtering money into a high yield emergency fund and have 5 percent going into my companies stock purchase plan I think I’m going well on the multiple streams of income deal.
If you can afford 50 bucks a month give it some consideration and start dollar cost averaging this bargain market!
January 18th, 2008 at 3:16 pm
“Comany’s” not “companies” up there and I forgot to add the expense ratio is .79 or around that. Not the best but the general rule is 1% or under so it qualified.
Cheers.
January 18th, 2008 at 3:18 pm
Grrrr. Only I could mess up a correction post with a typo. That is “company’s” not comany’s.
I need more coffee.
January 20th, 2008 at 4:53 pm
Taking it out–no.
But rolling it over to an IRA is a good idea.
February 8th, 2008 at 2:05 am
I’ve just skimmed over a few of the comments here, and I love to see that everyoneÂ’s 401k admin or plan advisors are educating the same dismal way. Here are a few of the comments I can add to your discussions.
-> If you roll money out of your 401k plan you will loss the employer contributions because of the companies vesting schedule. Usually a 5 year cliff, but it varies from company to company
-> Going from cash (money market) to stock funds can be useful in times of great uncertainty, BUT check out “market timing can be risky” on my website, or google it, and you will see trying to time the market is the worst thing you can do to your investments.
-> IÂ’ll check back in a few for comments.
December 25th, 2010 at 2:33 pm
Praise god for pension plans. I have no idea what I would do without them!!