With the latest market dip many questions have been raised regarding 401(k) accounts. These questions make it as clear as a neon sign that people do not understand how their 401(k) works.
Here are two recent examples that indicate this lack of understanding:
-I’m considering moving my money from my 401k to an annuity due to the market. I’ve already lost 10% this year.
-With the recent market tank, would you contribute to a 401(k) at this time or wait for this slump to pass?
Can you spot the common error in these questions?
I checked each of the comments for these questions hoping to see someone correct the writer’s misunderstanding of their 401(k). Unfortunately, ALL of the comments were perpetuating the error. It was clear that NONE of the commenters understood the workings of a 401(k). So let me clear this up and help you better understand your 401(k).
The overriding mistaken concept in these two statements is that a 401(k) is an investment. This misconception causes many people to do the wrong thing. A 401(k) is not an investment at all, it is a type of account where we park money to use when we retire.
A 401(k) is an account that holds investments, similar to having a filing cabinet drawer labeled 401(k). The drawer holds many different individual files. When we put something into the drawer, we put it into the appropriate file. When we put money into a 401(k) account, we invest it into one of the investments the 401(k) account has available.
When we make a deposit into a 401(k) account, initially the money deposited gets placed into a file labeled cash. At this point the account is working just like a checking account. But after the money is in the cash folder, we can choose to move it to a different folder by investing the money into something other than cash, such as Apple stock, an S&P 500 index mutual fund, a bond fund, or a certificate of deposit. This process is often automated. The 401(k) itself is not the investment, it is the place where we store the investment.
The rules for a 401(k) account are what make it so powerful. The rules dictate how the account can be used and what investments/file folders are available in the account. Each time money is deposited into the account we must instruct the account holding institution to invest the money where we want it invested. It is most often invested into the stock market in the form of purchasing mutual funds. The money can also be held in cash, used to purchase a certificate of deposit, buy an annuity (not recommended), buy a bond or bond fund, or any other investment depending on the rules of the account. We can have all our money in one investment/file folder, or better yet diversified into multiple investments/file folders.
With this in mind, it makes no sense to say we are moving the money out of our 401(k) to put into an annuity due to the market. If we are unhappy with having our money invested in the market, then we can sell the stock and invest the money somewhere else while leaving the money inside of our 401(k) account. It is not the 401(k) account that lost money in the market drop, it is the particular investments we put the money into that went down in value. Remember, the 401(k) account is not the investment, it’s only the place the investment is held.
In addition to the above questions, it would also be a mistake to ask, “What is my 401(k) worth?” Since 401(k) is simply the name of the account, it is not worth anything. When we ask the question that way, it perpetuates the idea in our mind that the 401(k) is an investment instead of an account.
A better question is, “How much money do I have in my 401(k) account?” All of the different investments/files we have are added together to give us the total amount of money stored in the account/file drawer.
Another good question is “Where is the money in my 401(k) invested?” This reminds us of the control we have inside the account. We decide how the money in our 401(k) will be invested within the rules of the account. Each 401(k) account has a list of investments that can be purchased, we decide where to invest our money among the available options. We can be as conservative or as aggressive as we want within those parameters.
The superpower of the 401(k), and every other retirement account, is the power held in the rules governing the account. It is those rules that make the account so powerful, not the investments you make inside the account.
A great rule for high income individuals it the instant tax deduction. Any money that goes into our 401(k) account is before taxes. So, if I deposit $100 into my 401(k) account, I have $100 available to invest. If instead I had decided not to put the money I earned into my 401(k) account, then I would have received a $60 paycheck and the other $40 went to the IRS for taxes. In this non-401(k) option I now only have $60 to invest. This tax deduction gives the investments inside 401(k) account a HUGE advantage over taking the money as salary and investing it elsewhere.
The optional rule of having an employer match a 401(k) deposit is another powerful advantage. That little rule creates a 100% instantaneously higher deposit in the account. If I deposit $100 into the cash folder in my 401(k) account and my employer adds $100 in matching funds, I now have an additional $200 in the account to invest. If I don’t deposit the money into my 401(k) account, I will only have $60 to invest in some other account. Seems like a no brainer regardless of the market conditions. Asking if I should deposit my money into a 401(k) if the market is down now sounds silly. Given the choice to have either $200 or $60 is an easy pick.
Another powerful rule is the gains made from the investments in the account are tax differed, allowing the investments to make higher returns within the account than they could in any other account. For example, if I had money in the account in a certificate of deposit and it paid $100, then I have an additional $100 in the account. But if that same certificate of deposit was invested outside my 401(k) account, taxes would come out of the interest, and I would then have only $60.
Many of the rules that make a 401(k) account deposit size increase feel the same as having an investment return. This might be why people mistakenly feel their 401(k) is an investment. But these boosts in the account value happen no matter what we invest the proceeds into. If I only have money in the account as cash, I still get the match and the tax write off. So even if I only have one folder in my 401(k) account file drawer, and I label the folder cash, my 401(k) account deposits create a great boost to my savings. But this isn’t actually investment returns, it is simply a deposit increase based on the rules of the account.
As long as we think of our retirement accounts as file drawers that contain file folders of different investments, and not as investments themselves, we will be able to make smarter decisions. We would realize the current state of the market is irrelevant to making the decision of whether to make a deposit to our retirement account or not. Deciding to put money into the account is entirely separate from deciding how we invest the money.
When choosing which investments to use in any retirement account, we should invest in a fashion that will let us sleep well at night no matter what the stock market is doing. We can change the type of investments, moving money from one file folder to another, any time we want. So, the person who was worried that their 401(k) had lost 10% should probably shift money inside their 401(k) from the stock market to a money market account, a certificate of deposit or a bond or bond fund so they will stop worrying about the market. They should not remove the money from their 401(k) and pay taxes and penalties.
Always keep the decision to deposit money into a retirement account separate from the decision of how to invest the money that is in the retirement account.
Retirement accounts are a great way to save money for retirement. Don’t use them for anything else and don’t treat the account as if it is the investment. It is just an account that has some pretty beneficial rules attached to it. Used wisely, these accounts can greatly shorten the time needed to reach financial independence.