The following is a guest post from Bernz JP who writes at Moneylogue.
More importantly, Should You?
When “life happens” it can be extremely tempting to use retirement accounts as emergency savings accounts. And while in an ideal world, you would never need to do this, sometimes it may be necessary. Statistics state that a little over 30% of 401K investors in the last decade have cashed out before reaching the minimum age of 59½ that let them avoid the 10% early distribution penalty.
IRS rules do make room for retirement plan loans if the maximum amount of the loan is either under half of the amount of your vested balance or $50,000, whichever amount is smaller. This means you won’t be able to borrow more than $50,000 from your 401K, no matter how much your plan is worth.
So, the question is, what counts a necessary and what doesn’t?
If your financial situation has become problematic and you’re eyeballing your 401K plan as a possible out, most financial advisors will tell you; you need to have a full understanding of the consequences before you move that direction. While borrowing from yourself might initially appear harmless and convenient, the long-term costs can end up being more expensive than you may realize. Here are some reasons to rethink borrowing from your 401K.
You’re Paying Taxes on the Same Money Twice
Yes, you will be paying yourself back with interest, but you’re using your taxable income to do it. This means you’ve paid taxes on the money you use to pay back the loan AND you’ll be paying taxes on that same money when you finally start using it for retirement.
Lost Income from Compounding Interest
Even with the interest, you pay back, no amount you can afford to pay will make up for the lost compounding interest the loan amount won’t make once it’s withdrawn from the 401K.
A Loan May Prevent You from Making Future Contributions
Not only will you lose the compounding interest from the principal you withdraw, depending on your plan’s regulations, but you may also be prevented from contributing new funds for up to six months. This ban on contributions means you will lose the pre-tax benefits from that money as well.
Once You Start – It’s Hard to Stop
Once you make the first loan and pay it back, it sometimes is difficult not to keep doing it again and again. Over time, this could greatly reduce the amount of income you’ll have available in retirement. As we stated above, once you lose the principal that is contributing to higher compound interest income, it’s virtually impossible to get it back.
Your Repayment Period May be Reduced If You Leave the Company
If you have to leave the company that holds your 401K before you’ve had a chance to pay back the loan, you may have to come up with the entire remaining balance in as little as 60 days.
This requirement will hold true whether you are leaving by choice or by force. Getting laid off will not protect you, which means you’ll be required to come up with the money at the worst possible time to be short on funds.
Scenarios That 401K Loans Could be a Good Idea.
Despite the drawbacks of 401K loans, there are some situations they might be a good idea, especially if all other options aren’t viable.
If You Own the IRS Back Taxes
Because of the penalties and interest that can build-up on overdue taxes, and the threat of wage garnishment to resolve the situation, a 401K loan may be your ticket out.
The additional money taken out of your paycheck to cover it probably won’t be any more than a federal garnishment would be, and you’ll stop accruing the higher interest amounts on the amount owed.
Before you go this route, double check with the other tax relief programs for alternative options.
If You are Close to Eviction and/or Bankruptcy
If you are facing a severe cataclysmic event financially, make an appointment to speak with a counselor from the National Foundation for Credit Counseling (NFCC). They will be able to assist you in determining what directions you can take to possibly get out of debt. If your 401K can help you buy some time to restructure your financial situation, they’ll be able to advise you on the best way to use the money. You can find a counselor in your area by visiting the NFCC website at http://www.nfcc.org.
If You are About to Default on Student Loans
Defaulting on your student loans can have a negative effect on your credit record, which can have an effect on future plans for quite some time.
Plus, if you’ve already had to declare bankruptcy and are also about to default on your student loans, you could end up with a double whammy on your credit record. In most situations, student loans don’t fall under the umbrella of bankruptcy, so you’ll still be responsible for them.
Weigh the Pros and Cons Carefully Before Moving Forward
Financial difficulties are usually a part of life at one time or the other. Getting them taken care of and quickly and painlessly as possible is the ideal way to overcome them. When considering using your 401K for this, you need to make sure the ends actually do justify the means. With the possibilities of penalties, loss of interest, and delay in additional contributions, the result could mean a greatly depleted retirement income.
Additionally, unless you are EXTREMELY secure in your current job, the possibility of having to come up with the balance of the loan in a short period of time, or suffer even greater consequences, could lead to more harm than the original loan did any good.
As most counselors will tell you, the only time you should seriously consider taking a loan out on your 401K is if your financial situation has come to an extremely bad point and it is the only option left to you to dig your way out. In those cases, make sure you know exactly what the effects could be so you can be as prepared as possible for any and all outcomes.