Fiscal Cliff’s Hidden Risks to 401k’s

The negotiations regarding the Fiscal Cliff are not going that well. There is the risk of brinksmanship that could result in a failure to resolve the cliff.

People ask “does the tax increase hurt 401k’s?”

The answer is that tax increases hurt the economy, making it fall into recession. This makes stocks go down in value. So 401k’s would be hurt by tax increases even though there are no taxes on 401k’s as long as the funds are left inside a 401k or properly rolled over to an IRA.

People ask “should I sell my 401k because of the Fiscal Cliff?” The technical answer is that funds in your 401k are stuck inside the account, but it is possible to sell off the assets and have the 401k hold only a money market fund that pays nothing. A more reasonable idea is to have the 401k hold mutual funds that hold investment grade bonds. These could go up in value if interest rates drop, although there is the risk that eventually rates will go up, making bond prices go way down. This could happen in a few years but one should be prepared for it to happen suddenly.

The real risk is that Congress would kick the can down the road with phony solutions that don’t fix the problem and that are financed by ever increasing amounts of debt, thus making the problem worse. Then investors might get lazy and dream that all is well instead of being aware of the growing mass of unserviceable debt and being aware that excess debt leads to recession or depression. This will make stock prices go lower in the long run; in the short run (when the Fiscal Cliff is resolved) stock prices could irrationally go higher causing investors to be fooled into chasing after a bubble and buying at the top of the market.

Until fundamental reforms are made to reduce the deficit then the economy’s problems will continue; to a certain extent the Fiscal Cliff is a phony crisis that distracts us from the real risk. It is like Y2K in 2000 where the Fed thought that computers would crash and ruin the economy so they created lots of “easy money”. This merely made things worse by making the tech stock bubble get even bigger. Ultimately the resulting crash was even bigger than it would have been due to excessive fed easing.

I have written an article “Election implies Fiscal Cliff to be fixed” and “Market getting riskier”.

Investors should seek independent financial advice.

Avoid these 401K Mistakes!