Retirement Planning – Why Borrowing From Your 401(K) Is A Terrible Idea!
Retirement Planning – Why Borrowing From Your 401(K) Is A Terrible Idea!
Many view their 401(k) as their own personal piggy bank. In a financial emergency it’s tempting to borrow money piling up in your 401(k). You don’t have to qualify for the loan and you don’t even have to give a reason for borrowing. So what’s the problem?
More and more 401(k) plans are offering loans as an option. Sometimes the loan option if offered as an incentive to get more employees to sign up for the plan. The loan option is offered in about 51% of all plans and offered in over 93% of plans with over 10,000 participants. Over the past 10 years the number of participants with outstanding loans has stayed steady at about 18%.
First, the problem with borrowing from your 401(k) is the lost opportunity of earning income on the money borrowed. Also, if you are financially strapped you will be unlikely to be contributing to the plan while you are paying off the loan. Some borrowers are also reluctant to start contributing again once the loan is paid off.
Another problem is that most plans won’t allow borrowers to choose which funds they take the loan from. If you want, for example, to take the funds from a low-yielding investment instead of a high-yielding one the plan will give you no choice and will take the funds proportionally from all your investments.
The loan is generally limited to half the amount you’ve contributed or $50,000 whatever is smaller. Payroll deductions are the usual means of paying back the loan.
Your 401(k) contributions are made before taxes but the repayment is made with after tax dollars. You’ll be paying an interest rate on the loan of prime plus 1% or currently about 8.75%. The interest paid goes back into your account. You must pay the loan back in five years. Watch out if you leave your job and you must pay back the balance with 60 days after you leave and in some instances within 30 days.
If you do not repay the loan the consequences are the same as if you withdrew the funds. You have to pay taxes on the funds and if younger than 59 ½ you’ll also have to pay a 10% penalty.
Overall borrowing from your 401(k), unless you are in desperate financial straits, makes no short or long term financial sense. Bottom line you are robbing yourself of your retirement assets.
If you borrow as little as $1000 and pay it back in one year, you’re 35 years old, and stop your contributions of 5% for the year and you’re earning $40,000. The employer in this example makes a 50% match. What does this loan cost you in general terms?
If you work until age 65 and the money you would have contributed over the one year you are paying back the loan ($2000 your contribution plus the $1000 from your employer) earned 8% annually you just lost over $30,100 from you retirement nest egg at age 65. By any measure, a very costly $1000 loan at age 35. (And we didn’t consider the tax costs of repaying the loan with after tax dollars, and the possible lost income over 30 years on the loan amount-the “real” cost could be at least double the $30,100.)
Almost without exception, loans from you 401(k) although easy to access, can be extremely expensive. Work out all your options before you take this step. Think long term and you’ll find another source of funds, or you’ll cut back you expenses or maybe a short term part time job will solve the financial problem.
Plan on putting something aside every payday to build up your emergency fund. This way the 401(k) will become much less tempting to borrow from and in the long run your retirement nest egg will grow and remain intact.
Andy Andersohn is a small business owner and long time tax preparer. Learn more valuable tax planning resources for business owners and individuals. Get your FREE 11 page Tax Saving Guide. Find up to date tax articles. At his tax planning site, discover more tax help and good ideas.