Don't panic and withdraw unneeded funds from your 401(k)

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One of the worst mistakes you can make right now is to withdraw money from your 401(k). Not only will you lock in the stock losses, but you'll pay a 10 percent penalty plus income tax on the money you take out.

Even if you are over the age of 59 1/2, when you no longer need to pay the 10 percent penalty, you still would have to pay income taxes.

You may think pulling your money out of your 401(k) will protect it from further declines. But if you are older than 59 1/2 and in the 25 percent tax bracket and withdraw funds, your cash will be reduced by another 25 percent. If you are younger than 59 1/2 and withdraw funds, you're looking at an additional 35 percent reduction.

Yes, your portfolio is likely hard hit unless it was 100% in a cash position. With the current market devastation, there really hasn't been a safe investment that was untouched. Both bonds and stocks were hard hit. In a recent study done by EBRI, it found that the average 401(k) of a person 56 to 65 lost about 25% of their investment if they were investing for about 20 years. If they were only investing for about 7 years, they probably saw a loss of about 29 percent. But, if you move that money to cash right now, you'll be locking in those loses and never recover from them.

Better than moving to cash would be to invest in a well-diversified portfolio of mutual funds. If you need ideas, one of my favorite mutual fund columnists, Paul Farrell, gives you a number of lazy portfolios from which to choose. I recommend you pick one and structure your 401(k) holdings to match the types of holdings in that portfolio.

For those of you who feel comfortable managing your own stock portfolio, you probably already realize we're in market that's at bargain basement prices. Yes, it's possible the market will still go down a bit more, but the bigger question for long-term investors is what is the best thing to buy now that will recover in two to three years. A good way to find out what your favorite investing gurus are doing is to visit GuruFocus.com and see what the top stock pickers are buying and selling. You'll find some great ideas. Put together your list of favorites and watch their stock prices. Immediately after a guru buys a stock you'll probably see a jump in price, so let the price float back down to normal before jumping in.

So how should you manage your 401(k) to maximize its lifespan and get the most from the recovery, which could still be a couple of years away? I recommend several steps as you get closer to retirement:

  • As long as you're more than 10 years from retirement, you can build a more aggressive portfolio with a good mix of growth and value stocks. Your mix can be as high as 80% (or more if you can stand the volatility) in stocks and 20% in bonds. With that much time to go you have the time for the market to recover from its recent crash.
  • When you're between 5 and 10 years from retirement, you should start moving to less aggressive stocks (blue chips and stocks that pay dividends) and increase your ratio of bond stocks. As soon as you're less than 10 years away from retirement, start shifting your portfolio to safer investments. Unfortunately in this recent downturn both bonds and stocks were hit. My favorite is a Ginnie Mae (Vanguard GNMA) bond fund that actually went up in value by 7.2% in 2008. (In the interest of full disclosures, I do own this fund). So with careful picking, you can find decent bond funds that won't lose big. Some of the biggest losers were bond funds that focused on commercial paper. So every bond fund is not a safe fund. Get to know your options.
  • When you're between 2 and 5 years from retirement, your portfolio should be at about a 50%/50% ratio of safer stocks to bonds. Research has shown this mix can extend the live of your portfolio, so you won't run out of funds in retirement. In my book, Working after Retirement for Dummies, I talk about this research in greater depth and show you how to mange retirement fund withdrawals.
  • When you're 2 years away from retirement, you should start moving the money you'll need for 2 years into a cash fund, such as a money market fund. That helps to protect you from having to sell an asset in its worst position.

Once you're in retirement, you should keep enough money in your money market to cover at least 2 years of cash needs. That should get you through any major market crash without being forced to sell into loses. As you sell bonds or stocks to convert into cash, sell the assets that have gains. By always keeping a cash cushion that matches at least 2 years of cash needs, you should always be able to find an asset that can be converted at a gain 2 years out. If it's a really bad period, you can wait 6 months to a year to find a good conversion if you have a 2-year cushion. Remember, as long as you keep that money in the 401(k), you don't pay taxes on the gain until you take it out.

A big mistake many retirees make is to move 100% of their portfolio into cash and bonds. Every portfolio needs growth assets. Most people live 20 years in retirement, so be sure to leave some growth assets in your portfolio throughout most of your retirement. At a very minimum, you should maintain at least 20% of your portfolio in growth assets until your very near your projected lifespan. How do you figure that? One of my favorite is the Life Expectancy Calculator at MSN.

Lita Epstein has written more than 25 books, including Working after Retirement for Dummies and Trading for Dummies.

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