The quick fix for rising expenses can be expensive long term.
According to a recent survey from insurer Nationwide, 22% of 401(k) savers have cut or are considering cutting 401(k) contributions to deal with inflation. The stat isn’t surprising. After all, trimming retirement contributions is an easy, immediate way to add cash to your budget.
The thing is, there are major drawbacks to reducing your retirement contributions — drawbacks you should consider before you implement this strategy. Explained below are two compelling reasons why you shouldn’t cut 401(k) contributions in these inflationary times.
1. Stocks outperform inflation long-term
Over the long run, the average annual growth rate of the stock market has been about 10%. That’s three times higher than the long-term inflation average of 3.24%. It may not feel like it but ongoing investing in your 401(k) protects the purchasing power of your retirement wealth, long term.
Another dynamic to consider is the state of the market in 2022. Year to date, the benchmark S&P 500 index is down more than 11%.
Many investors view downturns like this as an opportunity to pad their share counts at a discount. Reducing your retirement contributions would let some of this opportunity slip away, which ultimately means less long-term protection against inflation.
2. The cost of lost future earnings can be huge
The big cost of lower retirement contributions is the lost earnings. These amounts add up, especially if you’re young.
Say you are 22 years old, and you cut your 401(k) deposits by $200 monthly. That action could lower your 401(k) balance at retirement by $450,000. This number assumes two things. One, your 401(k) is invested to earn 6% on average annually after inflation. And two, you’ve forgone the $200 monthly contribution until age 65.
A short-term reduction of your contributions can also be expensive. Under the same assumptions, skipping out on the $200 contribution for a single month could lower your balance at retirement by more than $700.
When you should cut retirement contributions
Despite the drawbacks of cutting retirement contributions, there are situations when it’s justifiable. You might have been barely making ends meet before prices started rising, for example. If your landlord raises the rent and your budget can’t support the change, taking the cash from your contribution temporarily beats using a credit card.
You may also need to trim retirement contributions if you have minimal cash savings. An emergency fund balance is critical to your financial stability, especially if your job outlook is uncertain. Temporarily redirecting 401(k) contributions into a cash account could prevent bigger problems later.
A last-resort option
A reduction in your 401(k) contribution can be a quick fix for an unbalanced budget. Unfortunately, the strategy can also put a comfortable retirement out of reach long term. That’s why tapping your retirement contributions is usually a last-resort option. Do it if you must, but make sure it’s a temporary fix.
Whether you raise your income or downsize your expenses, find a way to restore your full contributions as soon as possible.
