Having a 401(k) or other retirement plan means you are making a concerted effort to save for your future. However, every year, thousands of people tap into their retirement fund to pay off existing debt. By borrowing from your 401(k) in the present, you are compromising your future, essentially defeating the purpose of having a fund in the first place.
Let’s review the impact of putting a crack in your nest egg.
What happens when you borrow from your 401(k)?
- Many employers will allow you to borrow up to 50 percent of the money in your 401(k) or retirement plan, up to $50,000.
- Fees vary because some employers charge you for taking out the loan, some charge a yearly fee while the loan exists and others may require a fee (up to $100) just to complete paperwork.
- Interest rates are 1-2 percent above the prime rate, which is the basic rate set by the government.
- In most cases, personal loans have a maximum repayment term of five years, with equal amounts taken from your paycheck over the course of the loan. While some plans allow you to pay off the loan early, most plans don’t allow you to change the payment terms.
- Deciding which of your investments are cashed in varies company to company. It’s best to check with your human resources team because some companies let employees decide and some do not. If the choice is yours, meet with your financial adviser and discuss what is best for you. Often, people choose to liquidate money in their money-market funds, bond funds or ill-performing equity funds. Your adviser can help you see which funds had high, low and consistent returns.
Borrowing from your 401(k) is a bad idea for a few reasons:
Saving Comes to a Standstill
If you borrow from your plan, it’s likely there’s a rule that prohibits you from making contributions until the loan is repaid. If there’s no such rule accompanied with your plan, the reality is, you probably don’t have extra money to contribute to your account (hence, the need you felt to borrow from it).
You Lose Money and Time
Having a retirement fund revolves around the premise that your money would grow over time. Since you’re not contributing to your fund, it’s a double whammy. The balance that you borrowed is missing out on potential growth as well as the contributions you would’ve normally made. Since many financial planners figure your money doubles approximately every 8 or 9 years, you’ll probably never regain the total you would have had if you didn’t withdraw that money.
You’ll Be Taxed Twice
If you tap your 401(k) to pay off current debt, you will be taxed twice on the loan amount. The fund you’re borrowing from is money you contributed before taxes, but the money you use to pay off the loan is after taxes. Then, when you’re ready to retire and want to withdraw money, you’ll be taxed again. Ouch.
The Hole Keeps Getting Deeper
If you can’t repay the amount that you borrowed in five years, your loan will be considered in default. The IRS and your employer will treat the remaining balance as a withdrawal, and you will pay income taxes on that money as if it were your regular pay. If you’re under age 59.5, (which most people are when they withdraw from their account) you will also have to pay a 10 percent early-withdrawal penalty. Which then puts you in a deeper hole, because if you don’t have the money to pay off the loan, how are you going to come up with the money for the penalty fee? Take more out of the 401(k)? And the vicious cycle begins.
As long as you have a loan, you are stuck at your current place of employment. Why? If you quit your job, go somewhere else or get fired, most plans require that the loan be repaid in a lump sum within days or weeks of your departure. If you can’t pay it off at that time, the balance will be taxed as ordinary income and you’ll pay a 10 percent penalty (if you’re under age 59.5) as mentioned above.
As you can see, it’s quite costly to borrow from yourself. Before considering a withdrawal from your retirement account, evaluate your spending practices. You shouldn’t have to borrow against your future for your lifestyle today. By being more aware of your expenses now, you can live a more comfortable life in the present and enjoy a little more security in your golden years. You can also review retirement savings tips for every age on the Zing blog.
Victoria Araj writes for Quicken Loans and loves that it’s one of the most amazing places to work. Check out the Quicken Loans YouTube page and learn more about what it’s like to work at QL.