The Dangers of Borrowing Against Your 401K

Discussion in '401k, IRA and Retirement' started by admin, Aug 15, 2014.

  1. admin

    admin Administrator Staff Member

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    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 401K 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% of your plan balance or $50,000 – whichever is less.
    Here are seven reasons why these loans can be very bad deals for you.

    1. 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.

    2. 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% 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.

    3. 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.

    4. 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% early withdrawal penalty to boot. That hurts.

    5. 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 service for any reason. If you are unable to do so, that would be considered a default and as I’ve explained above, that’s very costly.

    6. 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. (Cue bad tone.)

    7. 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.

    http://finance.yahoo.com/news/dangers-borrowing-against-401k-110058679.html
     
  2. Kate

    Kate Senior Investor

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    Excellent read here... thank you for posting it! Although our 401K isn't nearly as healthy as I'd like for it to be at this point, I have never once even considered borrowing from it. (I say not healthy because it's currently just not a good one :D and there are better ways to invest for retirement at this point.)

    Every one of these seven points is very serious food for thought to someone thinking about trying this and borrowing. It's hard enough to save sufficiently for retirement without borrowing every time a debt comes up that often most likely shouldn't have been made in the first place.
     
  3. JR Ewing

    JR Ewing Super Moderator Staff Member

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    Very good article!

    Anyone who has a half-decent 401k or similar plan available to them should do their best to max it out each year and otherwise try to leave it alone until retirement.

    And if no work plan is available, an IRA is essential. An IRA is also an excellent additional tax-deferred vehicle even with a 401k.
     
  4. springbreeze

    springbreeze Well-Known Member

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    I know someone who did this. She needed money to open a business. Unfortunately, the business didn't work and she lost all that money and more. It wasn't the best financial move for her. But at the same time she went after her dream. Now, was it worth thousands of dollars, I don't know.
     
  5. rylanU

    rylanU New Member

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    The money that you contribute to your 401k is yours. 401k loans allows you to borrow from yourself with all the interest being payed to you into your 401k account. Annually, numerous people elect to take a 401(k) loan. Unfortunately, most of them can't pay it back, as the quantity of 401(k) loan defaults has risen in recent years. Read this here: 401(k) Loan Defaults.
     
  6. Sugarhill

    Sugarhill Guest

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    I know of parents that have borrowed to help their kids with college. It would be hard to convince a parent otherwise, especially in the last or so.
     
  7. troutski

    troutski Guest

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    I know a few people that have borrowed from their 401K plans, and most of them have repaid the funds. However, I do know that most people do wind up defaulting because they borrow too much. You do pay a pretty steep penalty for withdrawing for a non-covered withdrawal, and people that are desperate for money are going to do it anyways.
     
  8. Rosyrain

    Rosyrain Senior Investor

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    Thank you for sharing, very informative. Is a 400 the best retirement option out there or are there smarter ways to invest money? Mine is ok, but I would like to have more money in it for my age.
     
  9. twinsmommy31

    twinsmommy31 Active Member

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    This was a great article. It is very true. Once you start dipping into your 401K you keep relying on it to get you out of financial jams. I have seem this with my own eyes. It is addicting and because the money is there, it seems to be fair game. Withdrawal fees do not matter to some. If they need they money they will take it. I know it is costly in the long run.
     
  10. Determined2014

    Determined2014 Guest

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    Those are some really good educating points,yes if one is not careful, thay might end up messing up their retirement plan and end up suffering, the loan sounds good and easy, but the consequences are tough.
     

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