Can You Lose Money in a 401(k) and How Does It Happen?

A 401(k) is a powerful tool for retirement savings, but it’s not without risks. Many assume their contributions will always grow, yet various factors can lead to losses. Understanding these risks helps in making informed decisions about retirement funds.

Market Variability

A 401(k)’s value depends on investment performance, meaning market fluctuations can significantly impact account balances. Stocks, bonds, and mutual funds experience price swings due to economic conditions, corporate earnings, interest rate changes, and geopolitical events. A downturn, such as the 2008 financial crisis or the COVID-19 crash, can lead to substantial short-term losses.

Asset allocation determines how much volatility affects a 401(k). A stock-heavy portfolio may see higher returns during bull markets but suffer steep declines in downturns. A more conservative mix with bonds and cash equivalents provides stability but limits long-term growth. Investors who neglect to rebalance their portfolios may take on unintended risk, especially as they near retirement.

Timing also matters. Those who retire or withdraw funds during a market slump may lock in losses by selling assets at depressed prices. This is particularly problematic for retirees relying on their 401(k) for income, as large withdrawals during a downturn can accelerate depletion.

Unvested Contributions

Employer matching programs can boost a 401(k), but not all contributions are immediately owned by the employee. Many companies impose vesting schedules that determine how long an employee must stay before gaining full ownership of employer contributions. Leaving a job before full vesting means forfeiting unvested funds.

Vesting schedules follow two structures: cliff vesting and graded vesting. Cliff vesting grants 100% ownership after a set period, often three years. Leaving before that time results in losing all employer-provided funds. Graded vesting allows employees to gain partial ownership over time—for example, 20% per year over five years—until fully vested.

Frequent job changes can lead to repeated forfeitures of employer matches, reducing overall savings. Someone who switches jobs every two years under a three-year cliff vesting schedule could repeatedly lose employer contributions. Negotiating a sign-on bonus or ensuring a new employer offers immediate vesting can help offset these losses.

High Expenses

Fees within a 401(k) can erode long-term returns, often without investors realizing their impact. These costs come in different forms, including investment management fees, administrative costs, and individual service fees. While they may seem small, they compound over decades and can significantly reduce savings.

Investment management fees, or expense ratios, apply to mutual funds and exchange-traded funds (ETFs). Actively managed funds often have expense ratios exceeding 1%, while passively managed index funds typically charge less than 0.20%. A difference of 0.80% annually may not seem substantial, but over 30 years, it can result in tens of thousands of dollars in lost growth. Many employees are automatically enrolled in higher-cost funds without realizing lower-cost alternatives exist.

Administrative fees cover recordkeeping, legal services, and other operational costs. Some employers absorb these expenses, while others pass them on to employees as a flat fee or a percentage of assets. A 0.50% administrative fee on a $100,000 balance translates to $500 per year, which increases as the account grows. Some plans also charge service fees for transactions like loans or rollovers, adding further costs.

Early Withdrawals

Withdrawing 401(k) funds before retirement age can lead to penalties and tax liabilities. The IRS generally imposes a 10% early withdrawal penalty on distributions taken before age 59½, in addition to treating the amount as taxable income. This can push the individual into a higher tax bracket, increasing their tax burden. For example, someone in the 24% tax bracket who withdraws $20,000 early could owe $4,800 in income taxes plus a $2,000 penalty, reducing their actual payout to $13,200.

Certain exceptions allow penalty-free withdrawals, such as total and permanent disability, medical expenses exceeding 7.5% of adjusted gross income, or a qualified domestic relations order (QDRO) in divorce cases. Unlike IRAs, 401(k) plans do not permit penalty-free withdrawals for first-time home purchases or higher education expenses. Some employer-sponsored plans offer hardship withdrawals, but these still incur income taxes and must meet strict requirements demonstrating an immediate financial need.

Loan Repayment Issues

Borrowing from a 401(k) may seem appealing since it avoids credit checks and traditional loan interest. However, failing to repay the borrowed amount on time can lead to financial setbacks.

Most 401(k) loans must be repaid within five years through payroll deductions. If an employee leaves their job before full repayment, the outstanding balance is often due within 60 to 90 days. If they cannot repay it, the loan is treated as an early withdrawal, triggering income taxes and a 10% penalty if they are under 59½. This can create financial strain, especially for those who lose their job unexpectedly.

Even when repaid on schedule, 401(k) loans come with hidden costs. Borrowed funds are removed from the account, missing potential market gains during repayment. If the stock market performs well, the opportunity cost can be substantial. Additionally, loan repayments are made with after-tax dollars, which are taxed again upon withdrawal in retirement, effectively resulting in double taxation. These factors make 401(k) loans a risky option that should only be considered when no better alternatives exist.

Rollover Errors

Moving funds from one 401(k) to another or into an IRA can be beneficial when changing jobs, but mistakes in the process can lead to tax liabilities and penalties. The IRS allows two types of rollovers: direct and indirect, each with its own rules.

A direct rollover is the safest option, as funds transfer directly from one retirement account to another without the account holder taking possession of the money. This avoids tax withholding and ensures the full balance continues growing tax-deferred. An indirect rollover, however, involves the account holder receiving a check, which must be deposited into a new retirement account within 60 days. Missing this deadline results in the entire amount being treated as a taxable distribution, with an additional 10% penalty for those under 59½.

Another common mistake is failing to roll over pre-tax and after-tax contributions correctly. Traditional 401(k) funds must be transferred to a traditional IRA or another pre-tax account to maintain tax-deferred status, while Roth 401(k) funds should go into a Roth IRA. Mixing these contributions improperly can create tax complications. Additionally, some 401(k) plans automatically withhold 20% for taxes on indirect rollovers, meaning the individual must cover that amount from other sources to complete the full rollover within the 60-day window. Understanding these rules can prevent costly errors that reduce retirement savings.