Disclaimer: If you have ever borrowed against your 401(k) or have borrowed against a retirement plan in general, you’re not stupid at all. You were just mislead, misinformed, not taught, or all of the above.
Here are the Top 10 Reasons to explain why you should never borrow against your 401(k)
1. You are Turning Off the Machine
This machine I am referring to is the same machine Albert Einstein dubbed the 8th wonder of the world: Compound Interest.
Here’s how it works:
Let’s say you you saved $2,000 inside a mutual fund of your 401(k). This year the mutual fund returns 10%. Therefore, you contributed $2,000 and the interest was $200, totalling $2,200 at the end of year one. Your money made money for you.
Now let’s say the next year you still contribute the same $2,000, and for mathematical purposes you get the same 10%. Well, since your money is compounding, you are going to get the 10% interest on the $2,000 from Year 1, the 10% interest on the $200 gains from Year 1, AND 10% interest on the $2,000 from the Year 2. So, you’re new balance would be $4,444 vs only $4,000 because of the compound interest.
I know you’re thinking it doesn’t seem like that big of a deal. However, try adding 1 – 2 zeroes to each one of those numbers! Now everyone is paying attention.
Another way to think about it:
Think of the money in your retirement account as a bunch of people who work for you for FREE. They consistently show up every day, and over time, they make you money without charging you for their services. Why would you ever want to get rid of those workers? This is exactly what you are doing when you pull money out of your 401(k).
2. You are Paying Yourself Back with Interest (and Losing)
Many people look at borrowing against your 401(k) as a win-win because you’re paying yourself back with interest instead of sending it to the bank via a home equity line of credit, a credit card, or some other form of debt.
The IRS has a lengthy explanation of how plan administrators set the repayment interest rate, but on average you can expect 1% – 2% above the current prime rate, which today is 3.5%.
Here’s why this is crap: The S&P 500, the benchmark used for mutual funds, has returned just over 9% over the past 5 years. If you were to pay yourself back with interest at 4.5%, you’re not only turning off the machine, but you’re also losing 4% – 5% in returns.
3. You Pay Taxes (Twice)
When saving money inside your 401(k), you are saving with pre-tax dollars. Your contribution is deposited tax-free, then the money grows tax-free, and you later pay taxes on the withdrawals as ordinary income. This is the absolute best benefit of your 401(k) account.
However, what many fail to realize is when you take a loan against your 401(k), you are paying yourself back with AFTER tax dollars. Then when it’s time to withdraw from your retirement account after age 59 ½, you are then taxed again! I have yet to meet anyone who has ever jumped for joy at the thought of paying taxes….let alone paying taxes twice on the same money.
4. Pay On Time or Pay a HUGE Fine
Usually the 401(k) loan must be paid back within 5 years. If you fail to pay back your loan in 5 years or less, your employer is going to treat the loan as an early distribution. This means you are going to pay income tax AND a 10% penalty if you’re under age 59 ½.
Here’s what this looks like:
Let’s say you currently earn $50,000/year and you borrow $30,000 from your 401(k). Then, life happens and you can no longer make the payments back into your 401(k) within the agreed time frame.
Now, your employer shows that $30,000 loan as income and the IRS tacks on 10% ($3,000) as penalty for early distribution before age 59 ½. That extra $30k in income also jumps you from the next higher tax bracket.
5. Your Risk Jumps through the Roof
If you have a 401(k) loan and you decide to quit or you lose your job, the balance is due in full in 60 days or less. Since most likely the money you borrowed has already been spent, this results in you having a lovely relationship with the worst lender on the planet – the IRS.
You also get the same added penalties mentioned above: 10% early withdrawal penalty and a chance to jump into the next tax bracket!
6. You’ll Receive Lower Paychecks
Most employers will start automatic paycheck deductions to begin the loan repayment immediately, which has a two-part effect. The first one is obvious – your paychecks are now going to be smaller.
The second one is a little more subtle.
Remember earlier when you were saving inside your 401(k) with tax-free dollars? Well, now you are re-paying your loan with after-tax dollars. If you are in the 25% tax bracket, that means you would actually have to earn $125 to pay $100 back to your loan.
How lovely for you.
7. There’s No Money Left to Invest
Now that you have automatic payments made each month back into your 401(k) and you’re taking home less money each paycheck, chances are you won’t have any money left over to contribute the amount you originally were into your 401(k). This lapse will result in 5 years of you not contributing to your 401(k) at the level you were before you decided to take that loan out.
To further explain what this looks like, a study by T. Rowe Price found that borrowing $10,000 from a retirement plan will reduce your account balance at retirement by $100,000.
Oh crap is right.
8. Now You’re Selling Low and Buying High
Any given 10 year period in the history of the stock market has made money, except from 2000 – 2010 where we experienced a dot com bubble burst, 9/11, a war, and the worst recession we have ever experienced since the Great Depression. On the flip side, 100% of any 15 year period has still made money.
Keep this in mind when you are borrowing from your 401(k). When you do this, you are actually selling off shares inside your mutual funds now and will be buying them back over the next 5 years. Statistically, you’re selling lower and buying at a higher price with what I just mentioned above.
Again, another horrible plan for your money.
9. You Didn’t Move the Needle
“I borrowed against my 401(k) to pay off all of my debt!”
False. You didn’t pay off your debt, you just moved it. Instead of owing the credit card companies, the car finance companies, or fill in the blank, you now owe on your 401(k).
Yes, you are absolutely paying a lower interest rate if you borrow against your 401(k), but let’s not forget about everything mentioned above. That lower interest rate comes with double taxation, losing the power of compound interest, increased risk with your employer and the IRS, and paying more for stocks you already own.
It’s sort of like a kick in the face with a golf shoe.
10. You’re Older Self Won’t Be Happy
Your 401(k) is for one thing and one thing only: Your Retirement.
Most people will take a loan against their 401(k)s to cover an unexpected emergency, or to fill the I want it now mentality. Why save up the old fashioned way, when I have this easier option sitting right here in front of me, right?
Wrong. Imagine this same emergency or the I want it now mentality when you’re 70 – 80 years old and you are barely scraping by each month.
Not fun my friends. Not fun at all.
Just DONT’ Do It
“But everyone is doing it.”
“Everyone” can also be translated into “normal”. If you’ve read anything on this site before, you know I am a huge proponent of stepping away from normal and doing things differently with your money.
Normal is living paycheck to paycheck, with a $600 car payment, and $28 in your bank account. Normal sucks.
If you need money and you think the only option is to borrow against your 401(k), I would do anything and everything you can to make sure this isn’t an option. If you need help with that decision, simply go back and read reasons 1,2,3,4,5,6,7,8,9, and 10.
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