How a recession could impact your 401(k)
It’s not a given that the economy will land in recession territory this year, or that any recession that ensues will be drawn out.
In 2020, the start of the COVID-19 pandemic triggered a major economic downturn as stay-at-home orders cost millions of Americans their jobs. However, that recession only lasted for two months.
Still, it’s essential to understand how a recession might impact your 401(k). There are a few ways that could shake out.
First, if the stock market slumps, the value of your 401(k) could decline. While stock market declines don’t guarantee a recession, concerns about a slowing economy can cause markets to drop.
Unemployment tends to rise during a recession. If you are laid off, you’ll lose the option to fund your 401(k), which can hurt its value over the long term. You also might struggle to pay your bills in general, leading you to potentially take an early 401(k) withdrawal or borrow against your balance if your plan allows for that. If you tapped into your 401(k) at age 31, you’d generally be looking at a 10% penalty, not to mention taxes on the amount you withdraw.
If a recession hurts your employer’s bottom line, you may not end up out of a job, but your employer might have to cut certain workplace perks, including whatever 401(k) match it currently offers.
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Learn moreHow to manage your 401(k) in light of recession fears
It's natural to be concerned about a recession's impact on your 401(k). But here's some good news: if you're 31 and plan to retire at a conventional age — meaning, at some point during your 60s — current events may not mean that much in the grand scheme of your savings journey. Since you won't be touching that money for decades, there's plenty of time for your 401(k) to recover from whatever losses ensue in the coming months.
That said, here are some steps you can take to safeguard your 401(k).
Make sure your investments are well-diversified
One thing that differentiates 401(k)s from IRAs is that they typically don't let you hold individual stocks. By effectively forcing savers into various mutual funds or ETFs, 401(k)s lend to more built-in diversification, and that’s a good thing.
Besides being diversified in terms of asset types, sectors, company sizes, countries etc., make sure your portfolio has the right asset allocation for your age. Since you’re investing for the long term, you can afford to take on more risk at your age.
Boost your emergency fund
You can safeguard your 401(k) by boosting your emergency fund. This lowers the chances of early withdrawal due to a financial emergency. A recent Empower survey found that over 20% of Americans have no emergency fund, and nearly 40% couldn’t afford an emergency of over $400.
A recession may seem like a good time to add money to your 401(k), as you can invest while the market is down. But it's probably not the right time if you're short on emergency savings. Personal finance expert Ramit Sethi recently recommended building a 12-month emergency fund instead of the usual one that can cover three-to-six months’ of expenses.
Once your emergency fund is fully funded, you can consider upping your contributions if your paycheck allows. With a $70,000 salary, that may or may not be possible. It's a matter of what your expenses look like.
Stay calm
Finally, do your best to stay calm if a recession hits. Try to avoid checking your 401(k) balance every day. Looking at day-to-day losses will only mess with your head and potentially drive you to make rash decisions that hurt you financially in the long run.
If retirement is still decades away for you, there's no need to shift to a more conservative 401(k) investment strategy just because a recession may be coming. Stick to your current long-term plan, and remember that the stock market has a long history of recovering from volatile periods like the one investors are experiencing today.
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