Is it wise to borrow from your retirement plan?
Borrowing from Your 401(k)
by Damon Carr
Should You Consider a 401k Loan to Pay Off a Personal Loan?
How a 401k Loan Affects Future Wealth
Using Your 401k to Pay Off Loans
Comedian Earthquake said, "Being in debt is worse than being broke. When you're broke, you simply need money. When you're in debt, you need money so that you can have an opportunity to be broke." Comedian Jimmy "JJ" Walker said, "Interest rates better go down soon or the murder rate is going to go up."
Americans are drowning in debt! In the past when people found themselves in a financial jam, they'd tap into the equity of their home to do a debt consolidation. If the situation was extremely dire, they'd file bankruptcy. Now that mortgage lenders and the bankruptcy code have tightened up their guidelines, millions of people are running out of viable options that would allow them to reduce their monthly payments and get a better handle on their money.
Because of diminishing options, people are looking at their retirement plans as their saving grace. There's a loan provision under 401(k) and similar retirement accounts that allow people to borrow the lesser of $50,000 or 50-percent of the vested balance. You can get up to $10,000 without regard to your vested balance. The loan under your retirement plan has to be paid within five years. You're entitled to a longer repayment term if you use the proceeds from the loan to purchase a home. There are no credit checks. Interest rates on 401(k) loans are generally lower than interest rates on other commercial loans. Lastly, when repaying a loan secured by your retirement account, you're in effect paying yourself back. No credit check, guaranteed approval, favorable interest rate, and you're paying yourself back. Sounds good! But is it wise to borrow from your retirement plan?
I'm of the opinion that a retirement account should serve its intended purpose, which is retirement. With Social Security on the brink of insolvency and Company Sponsored Pensions on the brink of extinction, saving for retirement and preserving your retirement savings has become more important today than it was in years past. As a result, I'm reluctant to advise anyone to borrow from his or her retirement account. Here's my reasoning:
Double Taxation: 401(k) loan payments do not reduce your taxable income in the same manner as 401(k) contributions. As a result, loans are repaid with after tax dollars. When it's time to withdraw money from the retirement plan, contributions and gains, which were previously taxed deferred, will be taxed along with loan payments that were already taxed at ordinary tax rates.
Hard to Pay Back a Loan and Continue to Make Contributions: When money is being deducted from your paycheck to repay your 401(k) loan, it reduces your disposable income. Most people are unable to repay the loan, pay general household expenses, continue to make retirement contributions and have a life. As a result, future retirement saving suffers.
No Company Match: Many companies will match your contributions dollar for dollar up to a certain limit, helping you accelerate the growth of your retirement savings. No company is going to match your loan repayments. If loan repayments force you to suspend making contributions to your retirement account, you forfeit company-matching contributions during that time.
Low Rate of Return: One of the pros of borrowing from a 401(k) plan is a low interest rate. When you're investing money, the goal is a high rate of return with acceptable risk, not a low rate of return. The investments inside your retirement were more than likely earning you a higher rate of return than the interest you're paying yourself.
Potential Taxes and Penalty: Should you leave your job willingly or be downsized from your job unwillingly the outstanding balance on your loan becomes due in full. If you're unable to pay the loan in full, the loan is considered to be an early distribution. You'll have to pay federal and state taxes on this money and you may have to pay a 10% early withdrawal penalty if you're under age 59 1/2 at the time of an early distribution. Taxes and penalties can run as high as 45%, depending on your tax bracket.
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I believe that the reason why seniors are awarded Senior Citizen discounts isn't because government and corporations are charitable. Senior Citizens are awarded Senior Citizen discounts because government and corporations know that most Senior Citizens are broke. How can this be? Many Senior Citizens had 401(k) plans and Individual Retirement Accounts. What happened? They tapped into their retirement accounts by way of loans and early withdrawals for various reasons, such as emergencies, debt consolidations, home purchase, home improvements, send children to college, vacation, etc. When it came time to retire, their retirement account amounted to a meager savings.
To avoid going into retirement with no money, I encourage people to avoid tapping into their retirement savings prematurely. After all, money inside a retirement account is protected from creditors. As an alternative to borrowing or prematurely withdrawing from your retirement account, I recommend that you temporally suspend contributing to your retirement plan. By temporarily stopping making contributions, you'll gain increased cash flow to help pay the bills. More importantly, you'll allow the money inside your retirement account to continue to benefit from the power of compounding.
Damon is the owner of ACE Financial. Damon has a solution for your financial problems and a plan to help you reach your financial goals - Regardless of current financial status!
Take the Next Step:
- When faced with a cash flow problem, it's better to temporarily stop making contributions to your retirement account than to borrow from it. After all, you don't want to miss out on the power of compounding.
- Know the risks if you intend to use a 401k loan to pay off debts.
- Learn more about the pros and cons of 401k loans before you borrow by visiting the Dollar Stretcher Library.
- Stop allowing debt to prevent you from doing the things you want. These 6 steps to getting out of debt can solve that problem. Get started today!
- Stop struggling to get ahead financially. Subscribe to our free weekly Surviving Tough Times newsletter aimed at helping you 'live better...for less'. Each issue features great ways to help you stretch your dollars and make the most of your resources. Subscribers get a copy of Are You Heading for Debt Trouble? A Simple Checklist And What You Can Do About It for FREE!
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