How to Protect Your 401(k) From a Stock Market Crash

Fact checked by Timothy LiReviewed by David KindnessFact checked by Timothy LiReviewed by David Kindness

As share prices rise in the course of a bull market, it’s easy to forget that the good times won’t last forever. Then the latest bear market arrives and suddenly your goal of a secure retirement looks a little further off with every new financial statement. What should you do when the going gets rough?

These four steps will help you bear-proof your 401(k) plan.

Key Takeaways

• Markets go down as well as up, so crafting a solid investment plan to reach your retirement goals is key.
• Be sure that your 401(k) investments are diversified across asset classes to minimize risk.
• When markets do fall, don’t sell in a panic. Instead, consider buying at discount prices.
• Try to avoid making 401(k) withdrawals before age 59 ½, as you will incur taxes on the withdrawal (unless you have a Roth account) in addition to a 10% penalty.
• If you are closer to retirement, it’s smart to shift your 401(k) allocations to more conservative assets like bonds and money market funds.

1. Set Your Goals

Stumbling through a market losing streak without a strategy makes a frustrating situation worse. If you don’t know how much money you need to achieve your retirement goals, you won’t be able to accurately assess the damage when the markets take a tumble.

Investing isn’t about trying to pick a hot stock or mutual fund and riding it to the moon. Focus on setting a realistic goal and tailoring your investing strategy for reaching it. Consider how much time you might need to reach your objective, and have a backup plan in case things don’t go as well as expected.

2. Plan Your Asset Allocation

After you’ve determined how much money you will need, the next step is to figure out how your investments can help you get there.

Asset allocation is key. Your money should be diversified between stocks and bonds to help you ride out market storms, though the allocations will vary with factors like your age and risk tolerance. Younger savers have more time to recoup bear market losses, and so may benefit less from the advantages of bonds in lowering the risk and volatility of a retirement portfolio.

Diversifying is especially vital if your employer’s stock makes up a big chunk of your retirement portfolio. If the stock market is in trouble, having too many eggs in a single basket could devastate your returns. Limiting employer stock to no more than 10% of your holdings is a good rule of thumb.

Note

98% of the 401(k) accounts surveyed in one study made no plan changes in March 2020 as the S&P 500 plunged as much as 34% from the prior month’s highs.

3. Don’t Panic

It’s fine to bear-proof your portfolio during a market downturn, and steps like diversifying and moving away from riskier stocks (and equity mutual funds) can pay off long after the bear market is over. Just don’t succumb to the temptations of panic selling.

In times of market stress, the urge to sell everything can be overpowering. But stocks have recovered from every bear market in the modern era. This time or the next time could always be different, but based on an extensive historical record, there is a strong probability that your paper losses will eventually be erased by subsequent market gains—unless, that is, you lock them in by selling at the lows.

What should you do during a bear market? If you had a long-term investment strategy in place before the markets took a dive, it’s time to revisit your plan. Are your goals still the same? Is your retirement still years in the future? If the particulars of your situation haven’t changed, this is no time to change your overall investment strategy. Stock prices rise and fall. Just because they have fallen doesn’t mean your strategy should change.

Remember, if you take withdrawals from your 401(k) account while under age 59½, you will be hit with a 10% penalty. If you have a traditional 401(k), not a Roth 401(k), you will also pay income tax on the withdrawn amount. Withdrawing from a tax-deferred savings vehicle like the 401(k) when you’re not required to do so also gives up a valuable tax benefit, since 401(k) plans defer capital gains taxes. The combination of the tax liability, the 10% penalty, and forfeited future tax savings can be toxic for your retirement goals, and that’s before considering the risk of selling at or near market lows and missing out on the rebound.

4. Keep Investing

When the markets drop, lots of people want to sell and get out. That’s an emotional impulse driven by fear. Consider instead that reduced share prices might amount to a sale.

If something you wanted—a car, a computer, a weekend getaway—was on sale at a discount, you’d probably be tempted to snap it up. The risk of even lower prices in the near future leaves many unwilling to load up on equities during a bear market. But just as markets don’t rise forever, they don’t fall forever either. Don’t reduce your 401(k) contributions, or the allocation of new savings to stocks, just because the stock market is struggling at the moment.

In fact, a bear market is often the right time to increase the percentage of income you contribute to your 401(k) if you can afford to do so. If your employer offers a matching contribution, raise your contribution at least to the level of the maximum match. Securing the largest possible employer match is the easiest, least risky investment you will ever make, and will help your plan recoup its bear market losses that much faster.

Important

Over the long term, the stock market has generally gone up. Use that trend to your advantage.

What Happens to My 401(k) If the Stock Market Crashes?

If you are invested in stocks, those holdings will likely see their value fall. But if you have several years until you need your retirement account money, keep contributing, as you may be able to buy many stocks on sale. Most 401(k) plans have a restricted set of allowed investments, so you likely won’t be able to sell short or buy inverse ETFs. Instead, you may want to shift some stock holdings into bonds or money market funds if you are closer to retirement.

Can You Stop Your 401(k) From Losing Money?

In a down market, you could transfer all of your holdings to cash or money market funds, which are safe but provide little to no return. (They may not even keep up with inflation.) This, however, is not typically advised unless you are nearing retirement. Most retirement savers should continue to contribute to their plan and stick to their strategic asset allocation, since buying the dips should allow the portfolio to grow even larger over the long run.

Should I Cash Out My 401(k) If the Market Crashes?

No. If you cash out your 401(k) plan, you will have to pay the deferred income tax liability on all of the contributions and gains in the account at that time. Moreover, if you are under age 59 ½, you will be hit with a 10% early withdrawal penalty, making it an even less attractive option. Instead, it is recommended to keep investing as the market dips and stick with your strategic plan.

The Bottom Line

Stock markets and economic cycles go through a rough patch every now and then. Don’t let the volatility make you forget that stocks tend to rise over time as listed companies earn returns on invested capital. This longer-term historical trend is your friend.

Invest when assets are on sale and their owners are panicking. Stay rational and level-headed. Even the worst economic crises eventually give way to a recovery.

If you’re young enough, you likely have decades of saving and investing ahead. Raiding your retirement fund early or shunning stocks during bear markets has huge long-term costs. Stay the course, if you can.

Read the original article on Investopedia.