You are already dealing with increasing debt. Suddenly, you find yourself with an unplanned expense that you cannot afford. You look longingly at your 401(k) balance. If only you could access some of that money to meet your current needs….
In many cases, you can access that money without penalties by borrowing from your 401(k) — but most experts agree that borrowing against your retirement plan is a bad idea, for a variety of reasons.
Borrowers may not understand the long-term harm that they are doing to their retirement account, or they may understand it but still rationalize a retirement-backed loan as their best option. Greg McBride, Chief Financial Analyst at Bankrate.com, uses the example of borrowers thinking that they are harmlessly paying money back to themselves but forgetting about compounding and the time value of money.
Such borrowers do not realize, says McBride, “…you’re dealing yourself a permanent setback to your retirement planning. You’re going to spend time and money putting money back into that 401(k) plan instead of putting new money in … you’re always going to be behind where you could have been.” Your missed opportunity for compounding interest cannot be recaptured.
In addition, you are subject to double taxation on your loan repayment. As you repay your loan, you are replenishing a pre-tax money supply with post-tax dollars. The account does not distinguish between those dollars, so you will pay tax on the repayment funds a second time when you draw them out at retirement.
Adam Carroll, Founder and Chief Education Officer of National Financial Educators, suggests that people wanting to borrow from their 401(k) or Roth IRA consider how they came to need a loan in the first place. “What they’re doing is they’re sacrificing their future financial success and their security for today’s present problem. And today’s present problem is a result of either overspending or not making enough money. Typically, they’re lifestyle choices.”
Essentially, too many people live beyond their means. A 2016 survey found that one in three Americans had no retirement savings at all, while a second survey found that 69% of Americans have less than $1,000 in a savings account.
Budgeting is key to living within your means. If you budget and maintain an emergency fund as part of that budget, you are more likely to handle larger but transient expenses without overextending yourself enough to require a loan.
McBride also points out another major risk of 401(k) loans: the possibility of losing your job or switching jobs during the loan payback period. “You’ve got 60 days to repay that outstanding balance on the 401(k) loan. And if you don’t, it’s treated as a taxable distribution; and if you’re under age 59-1/2, you also get socked with an additional 10% early withdrawal penalty.”
In the end, the choice is still yours — but take the advice of Certified Financial Planner® and WealthClinic® founder Leisa Peterson: “Proceed with a lot of mindfulness about what you’re doing and why you’re doing it.” If you are going to take out a 401(k) loan, Peterson asks, “Are you going to sleep better at night because you’ve done that?…If you do it, then now you need to make [it] a really high priority to restore that savings back into your retirement account.”
If you do proceed with a loan, be sure to compare the 401(k) loan to other loan options such as a conventional loan or a home equity line of credit (HELOC). You may find better terms with more conventional options — and if the options are equal, it’s preferable to refrain from disturbing your retirement funds.
Generally, you should avoid the temptation to borrow against your 401(k) — because, like many temptations, a retirement-backed loan may make your life more pleasant in the short run, yet you are likely to pay dearly for it in the long run. A loan against your retirement plan should be one of your very last resorts. At the end of the day, there’s usually a better way to cover expenses.
This article was provided by our partners at MoneyTips.com.
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