With news about a potential recession dominating the headlines, you may be worried about how it may affect your 401(k). And if you take a look at that account now, you may notice that your balance has taken a nasty hit. Unfortunately, we're still recovering from a bear market -- a period when the stock market drops by 20% or more from a previous high
But don't fret. There are certain steps you can take to protect your retirement savings from a recession.
1. Don't sell off your stocks
As the market drops, your first instinct may be to sell off your stocks before they dip any lower. But that's rarely a good move. Markets recover and if you sell your retirement plan stocks now, you'd miss out on the gains and compounding interest that recovery can bring.
In fact, the last recession which was triggered at the onset of the COVID-19 pandemic in 2020 ended with the S&P 500, a common benchmark for overall stock market performance, peaking at a record high four months later. It gained 50% from its March 23 low when it dropped about 30% from its previous high.
"Resist the urge to sell the investments within your 401(k) solely due to recent turbulence," said Brent N. Bruggink, director of retirement plan services at CG Financial Services. "Selling your investments can solidify losses. It can be challenging emotionally, but staying the course may ultimately be better for your account."
2. Keep contributing to your 401(k)
In light of a recession and record inflation, you may think it's ok to press the break on 401(k) contributions. But that's rarely the best path to take.
It may hurt you in the long run if you stop contributing to your 401(k) during a recession. Not only will you miss out on compound interest, but you also won't benefit from any gains when the market recovers.
But a market rebound won't be the only thing you'd miss out on if you stop contributing to your 401(k). You'd also miss out on any employer matching contributions to your 401(k). That's the closest to free money most people would ever get.
Image source: Getty Images
Moreover, you'd miss out on the immediate tax benefits of a traditional 401(k). Every time money comes out of your paycheck and moved into your 401(k), you're technically lowering your taxable income. This means that come tax time, Uncle Sam taxes less than your actual income for the year. Because our tax system is progressive, less income means less taxes.
Consider this. Say your income is a $85,000 salary. And you contribute $500 a year to your 401(k) through payroll deduction. If you don't contribute to a 401(k), you'll get taxed on the entire $85,000. But if you contributed $6,000 to your 401(k) that year ($500 x 12), you'd be taxed on the difference or $79,000. And the money you socked away for retirement keeps working for you.
While it's discouraging to invest in something that may be losing money, it's important to stay the course when it comes to retirement savings, which is a long-term strategy.
3. Increase your 401(k) contributions if you can
It may sound crazy to invest more money in your 401(k) if it has been going down lately and market volatility is running wild. But there's a silver lining to a low stock market, because the money you contribute to your 401(k) is essentially buying stocks at a discount. In other words, your money buys more shares now.
So when the market recovers, you'll have more shares that can increase in value.
And it will recover. Granted, the 2020 recession was the shortest in history thus far. But according to data published by the International Monetary Fund (IMF), the average recession lasts only about 11 months. And if you're worried about the bear market, that goes away too. According to data published by the investment advisory firm Hartford Funds, the average bear market lasts just about 9.6 months
"There is a silver lining," said Keith Naimot, chief operating officer of Group Retirement at Equitable. "Most recessions are followed by a recovery that includes a significant rebound in the stock market."