The practice of "rebalancing" your 401k is tricky, because it involves assessing how your portfolio has changed over time and moving the money around to best suit your retirement goals. Because of how different mutual funds perform, your 401k might become unbalanced without you even noticing.
Think of it this way: You have $10,000 in a fast-moving stock fund and $10,000 in a low-risk bond fund. Your goal is to be allocated 50-50 between the two. Well, if the bond market is flat and your stock fund goes up 50%, you now have $15,000 in stocks and $10,000 in bonds. You're now 60-40.
So what do you do? You rebalance. Take $2,500 out of your stock fund and transfer it into bonds so you can return to a 50-50 mix.
This is a key part of risk management, because over time you might not notice that the lion's share of your portfolio is in risky, fast-moving investments. It's a good problem to have, of course, that one part of your portfolio has grown so fast. But if you don't move that money around, you could expose yourself to disaster if things turn the other way.
There's a catch, though: Some 401k plans have a cap on the number of transfers you can perform annually. If you exceed that number, you might have to pay a fee. So while rebalancing is important, it shouldn't be overdone.
A good rule is to rebalance once a year, at tax time, with the help of your accountant or financial adviser, if you have one.
Cashing out early
The hard reality of the current economic environment is that many people have had to tap their 401k's to make ends meet. But this should be your last resort.
For starters, if you withdraw money before age 59½, it not only will be taxed, but you'll also absorb a 10% early-withdrawal penalty. (There are limited exceptions to this.) So all that hard work you put in to save will be offset by steep charges for taking money out early.
Also, removing $10,000 now can cut much more than $10,000 out of your total nest egg. A 5% average return annually will turn that $10,000 into more than $16,000 in 10 years. Presuming your 401k performance is good, you are forfeiting the potential profits you'll generate with this investment in addition to the principal.
Never take a loan from your 401k plan or cash out early if you can avoid it. Depending on your circumstances, it might make more sense to put a few thousand bucks on a credit card or take out a home equity loan than to eat into your nest egg.
So think things through before raiding your retirement fund. The penalties are steep.