Sunday, December 21, 2008

Keep saving in your 401K

Many of the individuals that I have meet over the last month stopped saving into their employer sponsored plan.  The reason that they all gave, is that when they look at their account balance they have been losing their contributions.  That is not exactly the case but certainly looks that way.  What they are actually losing is past principal and earning.  If you have $10,000 in your account and make a $100 contribution and the losses in your stock funds are $350 for the contribution period, it looks like you lost your last contribution. What really is happening is you are now buying more shares for the same contribution.  If a $100 contribution bought you 10 shares of a stock fund, it now buys you about 20 shares. So when your stock fund goes back up $1, you make $20 on your last contribution.  This helps your account value come back much faster, but that is not the only reason why stopping contributions is a bad idea.

Let’s say you have two individuals, Sally Saver and Fred Freeloader (I was going to use Joe the Plumber).  Both 35 years old and saving $250 a month for retirement.  They both plan on retiring at the age of 65.  For simplicity sake we will assume they are both just starting to save. Because of the market they want safe investments earning 3.5% (not advisable but I want to make a point).  If Fred Freeloader waits 5 years to start making contributions he will have at age 65 $119,053 and Sally Saver would have $157,789, a difference of $38,736 more for Sally.   That is still not the whole story.  Sally would be paying less in federal income tax for five years all things being equal. This may be about another $3,500 in tax savings. The above example does not even take into account an employer match, which could have Sally's account balance much higher. 

Stopping contributions to your retirement plan is one of the worst things you can do.  If the losses in the stock market have you that upset, then ask the company that manages your plan if they have a guaranteed investment.  Be sure to ask if there are any strings attached with the guaranteed investment as there usually is.  This is the time to save more to make up for the losses, not give up on your retirement goals.  

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