Life happens, and sometimes you experience a financial hiccup. In these scenarios, you may consider borrowing from your 401k. But the decision to take money out of your retirement fund shouldn’t be made lightly. In many ways, it’s a trade-off between paying for what you need now and planning for later: Do you take the preferential interest rate a 401k loan offers, or do you find another solution and leave your nest egg alone?
Granted, tough times usually call for tough decisions. It can be tempting to dip into your retirement savings for a big purchase — a new car or a down payment on a house, for example. Unfortunately, it’s one of the worst financial decisions you could make. Here are five reasons why borrowing from your 401k is a terrible idea.
1. It’s a Compound Mistake
If you’re like many independent workers, your 401k is the only thing standing between you and ramen noodles for dinner every night when you retire. It’s one of the most vital investments you have, because it offers you the opportunity to retire early, spend more time with loved ones and ease future financial worries.
Why is your 401k so valuable? Simply put, it accrues interest. And that’s compound interest, one of the most powerful financial forces in the world. Over time, the value of your investment will increase. If, for example, you take out a five-year loan, you will wipe out a huge chunk of your retirement fund. And on top of that, you will have to pay the loan fees.
2. You’re Breaking the First Rule of Personal Finance
Reading Robert Kiyosaki’s “Rich Dad, Poor Dad” was my personal financial enlightenment. Since then, I’ve read more and more, and listened to innumerable financial experts. And the one thing they all seem to agree on: Kiyosaki’s “pay yourself first” mentality. The concept is simple: When you receive your paycheck or you’re planning your monthly budget, prioritize your investments. According to this concept, you shouldn’t make any exceptions, even when you’re settling debts.
The logic behind “pay yourself first” says that, yes, you might experience some psychological relief from paying your debts, but you’re not growing financially. More specifically, you’re not creating opportunities for financial growth if all you do is pay back loans. Borrowing from your 401k loan breaks this cardinal rule. Your debt repayment disappears from your earnings, and repayment comes around faster than you’d think.
As a freelancer, I have the opportunity to invest in a solo 401k, and every month I make sure to put money into this account. When I receive my paychecks, I also prioritize investing in myself through informative books and online courses.
3. Uncle Sam Visits Twice
Borrowing from your 401k is borrowing from yourself. And when you pay back your loan (and interest), you simply put back what you took. Right? Wrong.
One of the benefits of having a 401k is that it’s tax-free until you withdraw funds. You take a stipulated sum each freelance paycheck, put it into your 401k account and the rest of your earnings are taxed. The tax-free money in your retirement fund earns tax-free interest, too.
If you take out a loan from your 401k, the money you borrow is not taxable income, so it’s still tax-free. But when you put the money back in, you’re using income that’s already been taxed.
That’s like a normal bank loan, of course, but here’s the rub: The interest you pay on the money you borrowed is taxed because it’s part of your income. You put it into the 401k, where it earns interest as usual, then you withdraw it when you reach retirement. And the government taxes you again. So you’re paying tax on the loan interest twice.
4. You Risk Hefty Fines
Of course, life happens. You may lose your job, get sick and have to pay medical bills or lose your home due to a natural disaster. Unfortunately, no one truly knows what the future holds. The problem? No matter what happens, you must pay back your 401k loan within five years. This rule is set in stone.
And, in the event that you’re unable to pay, borrowing from your retirement fund will turn into an ongoing nightmare. Your loan will be treated as an early disbursement (i.e., income), which means you will have to pay taxes on it. You’ll also get hit with a 10 percent penalty for withdrawing under the age of 59 1/2.
5. You Defeat the Purpose of Saving for the Future
There’s a reason you likely don’t want unrestricted access to all your money: Having the right investment accounts in place will help you limit your impulsive spending, forcing you to save for the future. And trust me, you don’t want your money sitting in the bank doing absolutely nothing.
Sure, taking a loan from your 401k instead of a mortgage company may not feel like you’re accruing debt. But the reality remains that you still owe money. And the brutal truth is that borrowing from your 401k is stealing from your future.
The only time you should consider borrowing against your 401k is when there’s no other option and your need is extreme. It’s far better to step back from the situation and consider alternatives. Think critically about how you can work to better live within your means. Plan out your budget carefully, and consider renegotiating your credit agreements. By taking these steps, you may be able to avoid the financial consequences of borrowing from your retirement fund.