By Julie Jason, originally published on Forbes.com.
Millions Are Benefiting From Stimulus Checks: But Don’t Forget Safety With 401(k)s
Millions of people are seeking information about when they will receive their one-time CARES Act stimulus payments and additional stimulus measures that have been proposed.
These tax-free payments provide temporary financial relief for today. There is no question that those checks are welcome and beneficial.
In markets such as these, it is important not to forget the role of a 401(k) plan in one’s overall financial situation. In times of uncertainty, such as we are facing now during the coronavirus pandemic, safety is a big concern.
What does “safety” mean for a 401(k) participant? It could mean “going to cash,” that is, selling stocks and stock mutual funds that are declining or could decline in value. It also could mean bailing – that is, stopping payroll contributions to the 401(k) plan.
What’s The Motivation?
Behavioral economists tell us that we are driven by “loss aversion,” a desire to avoid losses. Stopping 401(k) contributions or going to cash are short term actions that can derail the long-term goal of retirement security.
What’s Better? A Plan
Instead, a 401(k) participant is better off having a plan for the inevitable down markets that a 401(k) investor is bound to face during his or her investment lifetime.
To arrive at such a plan, you need to do some digging and some soul-searching. To get started, follow these 12 steps:
- Review how much you are saving now through 401(k) payroll deductions. How frequently do you get paid? Monthly? Weekly? Biweekly? These payroll deductions fuel your 401(k) contributions. That means you will be buying investments at higher or lower prices with each payroll.
- Review how your current payroll contributions are being invested. How did you set up your instructions when you enrolled in the plan? Did you change them? What are those instructions now? For example, you could direct that ¼ of your payroll contribution be invested in a certain stock mutual fund, and the rest be invested in a hybrid (stock and bond) mutual fund. This is important to know, since your current investment direction for your contributions is only one type of investment direction you are making with your 401(k) plan. The other type is covered in the next point.
- Review how your 401(k) balances are invested. You will need to look at your 401(k) statement to find your invested balances. For example, your 401(k) account is worth $100,000 today; ½ of that amount is invested in an S&P 500 index fund, and the rest is invested in a bond fund. Balances need to be understood in light of your time horizon, as you will see in steps 4 and 5. The list of investment balances and the list of investment contributions can and in most cases should be different, since they serve different purposes. You control how your regular payroll contributions are invested (see step 2). And you control how your balances are invested.
- Consider your 401(k) contribution time horizon. Will you be contributing to your 401(k) until you retire? For example, if you are 25 years old and you plan to retire at 65, your 401(k) contribution time horizon would be 40 years. If you are no longer working, your 401(k) contribution time horizon is zero years, since you are no longer on the payroll.
- Consider your 401(k) retirement time horizon. This is different from your 401(k) contribution time horizon; you will contribute to your 401(k) as long as you are working. After you retire, you will still participate in your 401(k) (or a rollover IRA) as an investor, not as a contributor. Your 401(k) retirement time horizon can be decades long. For example, if you are 25, you have a 40-year contribution time horizon followed by a 30-year 401(k) retirement time horizon if you live to age 95. Taken together, that’s an amazing contribution and retirement time horizon of 70 years. A well-organized plan needs to address both time horizons.
- Consider the effect of the company match. If your plan matches, say, 50 cents on every dollar you contribute, how much should you contribute to take advantage of every penny of the match? Most plans top out at some percentage of compensation (for example, 6% of compensation). You will want to contribute a minimum of 6% of your compensation if you have such a plan. Why is this important? It helps you assess uncertainty and risk and plan for the future. Don’t forget that you lose your 50% match when you stop contributing.
- Consider the pretax nature of your payroll deductions. When you contribute pretax, your W-2 income goes down by the amount of your pretax contributions. That saves you money every year you contribute to your 401(k).
- Consider your RMD (required minimum distribution). The nice thing about 401(k)s is that no taxes have to be paid on capital gains or income generated by your 401(k) investments. Instead, the law requires that you start taking RMDs after a certain age (until recently, the starting age was 70 1/2, but under the SECURE Act, for those born after June 30, 1949, it’s age 72). RMDs are taxed at ordinary income tax rates. Think about how RMDs enter into the picture when you are retired and need money to pay living expenses. By the way, under the CARES Act, RMDs are suspended for 2020.
- Consider your legacy goals. If you want any 401(k) assets to pass to beneficiaries at your death, you need to think about your beneficiary designations. Are they up to date? Take the time now to make sure you have the beneficiaries listed that you want to inherit your 401(k).
- Consider your charitable goals. After you start taking RMDs, there is a way to direct all or a portion (there are limits) be paid to the charity of your choice, thus avoiding income taxes on that distribution. What are your thoughts about whether you will want to do this? For more information on “Qualified Charitable Distributions” or “QCDs” see IRA FAQs - Distributions (Withdrawals).
- State your 401(k) goal. Is it to protect your current 401(k) balance from declining at any time? Or is it to be able to pay for lifetime expenses after you stop working? Taking a stand on goals will help you define safety, security, and tackle the potential negative effects of loss aversion.
- Combine all of these elements so that you can optimize uncertain and downward markets when they hit.
- The drive to be safe is understandable, especially in uncertain times such as those we are experiencing now during the coronavirus pandemic. The focus, however, needs to be achieving retirement security.
If you are just starting to participant in your 401(k), when you direct your investments during the contribution timeline, don’t you want to buy more shares at a discount? You would want to direct those periodic investments into more volatile stock investments with higher expected returns, such as an S&P 500 index fund over, say, a money market fund. If your plan has a match, your contributions will trigger additional purchases at lower prices during a market decline.
If you are retired, direct the investments of your 401(k) balances based on your retirement time horizon, which can be 30 year or more. Now, you will want to incorporate your 401(k) or rollover IRA into your overall asset picture so that you can create cash flow to supplement pensions and Social Security retirement benefits. In some cases, that’s a straightforward exercise of matching needs against sources of income. In others, the job is more complex, and calls for the expertise of professionals.
The above steps will help you assess the information you need to formulate a plan that you can construct for yourself. The outcome will be unique to you. It will be the foundation that can support good 401(k) decision-making during your working career and throughout retirement.
What About You?
Have you made any changes to your 401(k) investments? Has your 401(k) vendor contacted you about making any adjustments to your investment selection since the pandemic began?
Click here to take a survey to let me know.
To read Julie Jason's books, go to https://juliejason.com/books/julies-books.