When looking to buy a house or just needing some quick cash, it’s not uncommon for people to look to their retirement accounts for easy money.
I usually advise against this and feel it can cause more damage to your financial security than good, and I’d like to explain why. Spoiler alert: we’re going to be doing math.
What is a 401(k) loan?
First, what does this mean? A 401(k) loan means borrowing from the money you’ve been putting aside for retirement. Most traditional plans will allow you to borrow up to 50% of your vested funds up to $50,000 at a relatively low interest rate for up to five years.
You will need to repay the money you borrowed plus interest, and the interest is paid into your account. Sounds like a solid plan, right?
Not exactly, and here’s why:
Pre-tax versus post-tax dollars.
When you contribute to a traditional 401(k), you’re putting money in that has not been subjected to tax. And, because it’s not technically a withdrawal, you’re not paying taxes on the money you take out.
So, you take out $10,000 and plan to pay it back in five years. The interest rate is 5%, which isn’t terrible. You set up a payment plan to pay $192.48 each month for five years for a total of $11,548.80 in payments
The money you are using to pay back yourself is going to be post-tax dollars. So, if you’re combined federal and state income tax bracket is 25% (just for simple math), you’re effectively paying 25% more than just the nominal principal and interest payments. It will take $15,398.40 of earned income to pay back the loan, including the income taxes and interest, with $3,849.60 of that going straight to the government.
The loss of growth.
While you’re paying back that loan, you’re losing the opportunity for it to be growing.
Say you leave that $10,000 in the account and it grows at 7% (again, just making up these numbers). Thanks to compounding, that $10,000 would actually equal $14,025.52 after five years.
So by taking that loan, you spent an additional $3,849.60 in taxes and lost out on $4,025.52 of potential appreciation for a total opportunity cost of $7,875.12 on a $10,000 loan.
Plus, some plans won’t allow you to continue contributing to your account while you’re paying back the loan, so you could be losing another five years of tax-deductible savings.
Then what?
You borrowed from your 401(k). You lost thousands to taxes and opportunity costs. But you’ve managed to pay it back. Now what?
You just lost five years of contributions to your account. Five years that could’ve been used for compounding your account balance.
When it comes to building wealth, time is your most valuable resource. The compounding power of interest can be the difference between gaining an extra comma in your account or not. It could be the difference between retiring at 50 and retiring at 65.
Unless your need to borrow funds is for an absolute emergency and you have nowhere else to turn, your 401(k) should remain untouched.
Other options.
I wouldn’t steer you away from one solution without at least suggesting alternatives. There are a few creative ways you can find money outside of your retirement plan.
If you own a home, a home equity line of credit can be a great way to borrow money at a low rate that won’t cause the same financial destruction.
For those who have family members with healthy savings accounts or Certificates of Deposit, outlining an intra-family loan could actually bring in extra cash for your relative while getting you the money you need. Even the highest interest savings accounts are generally only yielding half a percent. Instead, ask your relative for the $10,000 you need and offer to pay it back with just 2% interest. This small change in yield will raise their annual income from $50 to $200. As long as you stick to your payment plan, you can handle your finances and not ruin Thanksgiving.
If neither of those options are viable, a basic personal loan may have a slightly higher interest rate, but it will still cost you less overall due to income tax considerations.
The lesson:
Borrowing from a 401(k) seems simple, and the low interest rates and easy access can make it tempting. But retirement is the only expense in your life that you cannot borrow for. With pensions being nearly extinct and Social Security struggling to hang on, you will likely only have your savings to get you through your golden years.
Don’t let today’s financial mishap derail your retirement if you can find another option.