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. You can take the following three steps 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 could miss out on the gains and compounding interest that recovery can bring.
In fact, the last recession — 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 fell 34% between Feb. 19 and March 23, then gained more than 50%.
“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 okay to take a break on your 401(k) contributions. But that's rarely the best path to take.
Not only will you miss out on compound interest, but you also won't benefit from any gains when the market recovers. Worse yet, you'll miss out on any employer matching contributions to your 401(k). That's the closest to free money most people would ever get.
Moreover, you'd miss out on the immediate tax benefits of a traditional 401(k). Every time money moves from your paycheck to 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.
Suppose your income is a $85,000 salary, and you contribute $500 a month 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 only get taxed for $79,000 worth of income. 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) when its holdings have lost value and market volatility is running wild. But there's an upside to a low stock market: Any money you contribute to your 401(k) when the market's slumping is essentially buying stocks at a discount. The same amount of money can purchase more shares at a lower price — and when the market recovers, those extra purchases can magnify your gains.
And the market 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
It's easy to get scared and pull back on your retirement investments when the market heads south. If you're feeling particularly brave, you can face this opportunity head-on and increase your buying. But even if you don't, you can still benefit simply by sticking with what you've already been doing. When the market inevitably rises, chances are you'll be glad you did.
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Fool contributor Javier Simon holds no financial position in any companies mentioned. The Motley Fool has a disclosure policy.