The dangers of borrowing against your 401(k)
According to a recent TIAA-CREF survey, almost one in three Americans borrow against their employee retirement plans at one time or another. That must mean it's a smart move, right? Wrong.
As you'll see, borrowing money from your 401(k) or other retirement plan at work can be one of the very worst financial moves you can possibly make.
How 401(k) Loans Work
Not every employer offers employees 401(k) loans, but many do. And companies that do offer loans can elect to only grant those loans for specific purposes like education, medical reasons or first-time home purchases. In most cases the loan must be repaid within 5 years. (The only exception is if you borrow money for a home purchase. In those cases the employer usually allows you to repay the loan over a longer period of time.)
Loan payments are made directly from your paycheck, after tax. As long as you repay the debt within the time allotted, you won't have to worry about income taxes or penalties. But if you default, you could pay both income tax and the early withdrawal penalties.
The last limitation to be aware of is that the most you can borrow is 50 percent of your plan balance or $50,000 -- whichever is less.
Here are seven reasons why these loans can be very bad deals for you.
It's too easy to get your hands on the money
If your employer offers 401(k) loans, you'll probably find it a snap to get your paws on the dough. In fact, all you have to do is fill out a few forms and you'll probably have your money in a matter of days. In my experience, that's dangerous. Borrowing money is a serious business. The last thing you want to do is borrow money needlessly. And if it's easy to get the loan, you just might go for it without thinking it through completely.
It can be addicting
Once you start dipping into your 401(k) cookie jar, you may find it difficult to stop. Thirty-five percent of the people who take retirement loans do so to cover an unexpected emergency, according to the survey.
That means 65 percent of the people who take loans do so for non-emergencies. I'm sure that some of the people who took those non-emergency loans did so for good reasons, but it's also likely that many of the other people took loans for non-essential purposes and could have lived without whatever they spent the money on.
It masks the real problem
Forty-six percent of the people who took out loans against retirement plans did so to pay off other debt. I'm a fan of paying off loans. But a 401(k) loan is like borrowing from Paul to pay Peter. It doesn't address the underlying problem. Why did these people get into debt in the first place? Unless they figure that out, they are very likely to re-create that debt and go through their entire retirement savings. I've seen it happen many times.
The best way to get out of debt is to change your financial behavior and spending patterns. Then, cut your borrowing costs and try to earn more. Finally, put all you have towards reducing that high-cost debt. These actions are far more beneficial in the long-run because they address the core issue.
It’s expensive if not repaid
If you default on your loan, you'll find yourself far deeper in the hole. That's because the minute you default, you'll have to declare the money you still owe as taxable income. And if you are under the age of 59½ you'll have to pay a 10 percent early withdrawal penalty to boot. That hurts.
You get double-whacked if you lose your job
Most retirement plan loans require you to repay the loan within two months if you separate from the company for any reason. If you are unable to do so, that would be considered a default and as I've explained before, that's very costly.
You give up tax-free compounding
One of the big benefits of piling up dough in your retirement plan is that it grows, tax-deferred, and you often get an employer match for money you deposit into the plan. If you are busy paying off a loan, you have less cabbage to contribute to your plan. That means your retirement nest egg will be smaller and you may miss out on the sweet employer contributions.
You have less retirement income
As you can see, there are quite a few downsides to borrowing from your retirement plan at work. Chief among them is a permanent and meaningful reduction in retirement plan assets. And if you drop a chunk of your retirement assets you'll have a lot less retirement income when you finally retire.
Sometimes, taking a loan from your retirement plan is unavoidable. I understand that. But if you plan on going to your retirement account at work for a bail-out, make sure there are absolutely no other options. Then, take a hard look at why you face this predicament and work tirelessly to make sure you never find yourself in that position again.
Have you ever borrowed from your retirement plan at work? Why? Did you pay it back in time? Looking back, do you think it was your best move? Share your thoughts in the comments.
Neal Frankle is a Certified Financial Planner. He is the editor of Wealth Pilgrim and www.mcmha.org.