Put Your 401(k) Back to Work

Your best bet is to keep on contributing, stick with stocks and try not to raid your account.

The economic funk has made virtually everyone anxious about retirement. In fact, 83% of Americans worry that the recession will have a major impact on their retirement plans, according to a recent poll by the National Institute on Retirement Security.Don't let economic jitters change your savings habits. Sticking with the tried-and-true practice of socking away as much as possible in your 401(k) or IRA -- or both -- should still put you on track for retirement. But we don't blame you for being concerned that your 401(k) has turned into a 201(k). We answer some common questions about how to pump up your depleted accounts.

My employer has stopped contributing to my 401(k). Should I stop contributing, too? Absolutely not. Particularly now, with Standard & Poor's 500-stock index down 33% over the past year, you don't want to miss the chance to pick up stock-market bargains (see 7 Blue Chips to Hold Forever). Plus, if you stop putting money in your 401(k), you'll miss out on a valuable tax deduction. Say you're in the 25% federal tax bracket. If you contribute $4,000 to the plan, you'll save $1,000 in income taxes -- and even more when you include state tax savings.

I've already lost so much in my 401(k). Wouldn't it be better to keep my savings in cash until the market bounces back? You're in good company. Nearly one-third of those who participate in a 401(k) plan lost 30% or more last year, reports Mercer, a consulting firm.

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But if you sit on the sidelines and venture back into the market only after it turns around, you risk missing out on the market's top-performing days, which tend to come at the beginning of a recovery. For instance, if you were fully invested in the S&P 500 from December 31, 1997, through December 31, 2007, you would have received an annualized return of 4.2%. But if you missed out on the index's 30 best days during that time period, you would have suffered average annual losses of 7.2%, according to an analysis by T. Rowe Price. No one knows exactly when the market will recover in the future, so it is better to keep your long-term money invested in stocks for the long haul.

I thought my tolerance for investment risk was pretty high -- until the stock market collapsed. What should I do now? Investing and risk go hand in hand. How much volatility you can stand depends on your age, your investment goals and your ability to sleep at night. If you are within a few years of retiring or close to reaching the dollar goal you've set for your retirement kitty, lock in your savings by reducing your risk, says Richard Ferri, chief executive officer of Portfolio Solutions, an investment adviser in Troy, Mich.

For instance, if you've determined you need $1 million by the time you're 65 and you have accumulated $900,000 by age 60, take your foot off the gas and cut your portfolio's stock holdings by 10%. You'll feel as if you're taking action, but, in reality, the move won't affect your portfolio that much. Then don't touch it again for at least a year. "There's nothing you can do about a bad economy except wait for it to get good again," Ferri says.

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The volatile market has left my retirement portfolio completely out of whack. How do I rebalance? Decide on a rebalancing schedule -- quarterly or annually works well -- and stick to it. By rebalancing at regular intervals, you avoid subjective decisions based on emotion. Plus, you force yourself to sell investments that have performed relatively well and buy laggards to re-establish your original asset allocation. About half of all employer-based retirement plans offer an automatic-rebalancing feature, according to a new study by Hewitt Associates, an employee-benefits consulting firm.

Or consider investing in a target-date retirement fund, which adjusts automatically as you approach retirement. More than three-fourths of employers now offer target-date funds in their 401(k) plan, Hewitt says. Although these funds suffered in the market meltdown, too, they generally beat the S&P 500. Want to invest in a target-date fund through your IRA, which offers a broader range of investment choices than your employer's 401(k) plan? Eve Kaplan, a financial adviser in Berkeley Heights, N.J., recommends the funds in the Vanguard Lifestrategy series, each of which charges low annual fees.

My retirement portfolio fell 35% last year. How long will it take for it to recover? Unfortunately, it could take years. Let's assume you had a portfolio of $250,000 that fell 35%, to $162,500. If you don't add anything and earn pretax annual returns of 5% -- about half of the stock market's long-term rate of return -- it would take more than nine years for your account to recover, according to calculations by T. Rowe Price. However, if you add $4,000 a year and your investments earn 5% annually, your account would rebound to about $250,000 in six and a half years. Higher investment returns and larger contributions would produce faster results and a bigger nest egg.

I have both a 401(k) and a Roth IRA. Is that too many retirement accounts? No. It's actually a good idea to have both types of retirement accounts to diversify your future tax liability. With a traditional 401(k), you enjoy an upfront tax deduction, but future withdrawals will be taxed at your ordinary tax rate (not the lower capital-gains rate reserved for most investments). With a Roth IRA, you pay taxes now instead of later. But to contribute, your income can't exceed $120,000 if you're single ($176,000 if you're married) in 2009. Nearly 30% of employers offer Roth 401(k)s, which provide the same tax-free income in retirement but without income-eligibility restrictions.

I need to borrow money from my 401(k). What are the pros and cons? If you're facing a financial emergency and your only choice is between borrowing from your 401(k) plan or making a hardship withdrawal, it's an easy decision: Take the loan. You'll avoid the taxes and penalties that come with a hardship withdrawal. Most 401(k) plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less.

Although the money and interest you repay go back into your account, a 401(k) loan can still be costly. Money not invested will stunt the growth of your retirement savings. And if you fail to repay the loan on a timely basis -- usually within five years (longer if you use the money to buy a first home) -- you will owe state and federal income taxes, plus a 10% penalty if you are younger than 59. Together, the taxes and penalty can wipe out 40% or more of your balance. And if you lose your job, you usually have to repay the loan within 60 days or it will be treated as a taxable distribution. "If you take a loan, make sure you'll be staying at your job a while," warns David Wray, president of the Profit Sharing/401k Council of America.

Is there a way to avoid the 10% penalty if I tap my 401(k) before I turn 59? Yes. There's a special rule for workplace-based retirement accounts. If you leave your job when you are 55 or older, you can tap your retirement funds without paying the 10% penalty, although you will still owe income taxes. This early-out rule does not apply to IRAs, so if you roll over your 401(k) to an IRA, you lose penalty-free access to your money.

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Associate Editor, Kiplinger's Personal Finance