Nearly 20% of 401(k) plan participants who are eligible to take loans against their retirement savings exercise this option, according to 2008 data from the Employee Benefit Research Institute. This number has remained stable since the early 2000s.
The average outstanding loan balance was 16% of assets. For plan participants in their 20s, the number is much higher, coming in at 29% of their savings, a percentage that drops as participants age, falling to 25% for those in their 30s, 18% for those in their 40s and 13% for those in their 50s. The figure is just 11% for those in their 60s. While it's great that older workers tend to borrow less, dipping into your 401(k) plan at all is a bad idea. In this article, we'll go over eight major reasons why you should focus on keeping your 401(k) plan until retirement, rather than using it as a piggy bank. (For more insight, read Qualified Loan Plans: Guidelines To Operations, Should You Take A Loan From Your Plan? and Borrowing From Your Plan.)
Why Borrowing Is a Bad Idea
Pundits claim that your 401(k) balance is a less expensive way to borrow money because the interest rate charged is generally lower than the rates on a commercial loan. They also cite the fact that when you repay the loan, you are paying yourself back with interest, instead of paying a bank. Despite these claims, borrowing from your 401(k) goes against almost every time-tested principal of long-term investing. There are eight major reasons why this type of thinking is short sighted:
1. You Are Not Saving
If you borrow money from your 401(k) plan, most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn't have this provision, it is unlikely that you can afford to make future contributions in addition to servicing the loan payment. Because the whole point of having a 401(k) plan is to use it is as a way to save for the future, you are defeating the purpose of having this account if you use it before you retire.
2. You Are Losing Money
If you not are not making contributions, not only is the entire balance that you borrowed missing out on any potential growth in the stock or bond markets, but each future contribution that you are unable to make (since you have a loan outstanding) isn't growing either. The extraordinarily low interest rate that you are paying to yourself with your loan payment is likely to be a pittance in terms of return on investment when compared to the market appreciation that you are missing. Of course, there's also the fact that you are paying yourself back with after-tax money. If you are in the 25% tax bracket, earning $1 only gives you $0.75 toward repaying the loan, and that $0.75 will be taxed again when you retire and withdraw if from your plan. While the interest rate on the loan may be low, you are getting taken to the cleaners by its tax implications.
3. Time Will Work Against You
Long-term investing (such as saving for retirement) is based on the idea that, by putting time to work on your behalf, your money will grow. Most calculations suggest that your money will double, on average, every eight years. 401(k) plans permit each loan to be held for up to five years or longer. Therefore, if the loan is used to fund a first-time home purchase, loan holders not only lose out on what should have been an opportunity to nearly double their money, but they are also left unable to make up for the lost contribution and growth opportunities. Over time, their balance is unlikely to ever reach the total that it would have reached had contributions continued uninterrupted. (For more insight, check out Delay In Savings Raises Payments Later On, Understanding The Time Value Of Money and Why is retirement easier to afford if you start early?)
4. If Your Financial Situation Deteriorates, You Could Lose Even More Money
Should you find yourself in a position where you are unable to repay the loan, it is treated as a withdrawal and the outstanding loan balance will be subject to current income taxes in addition to a 10% early withdrawal penalty if you are under age 59.5. (For more on this, read Tough Times … Should You Disturb Your Qualified Plan's Assets?)
5. You Are Trapped
If you have an outstanding loan, most plans require that the loan be immediately repaid if you quit your job. So, as long as you have a loan, you are stuck in your current job and may be forced to pass up a better opportunity should one come along, unless you are willing to take the loan balance as a withdrawal and pay the 10% penalty, which further compounds the growth opportunities that you have missed by taking the loan.
6. You Lose Your Cushion
Taking a loan from your 401(k) plan should only be done in the direst of circumstances, after you have completely exhausted all other potential sources of funding. If you take money from your plan to fund a vacation or pay off higher interest loans, the money won't be there to borrow if you really need it.
7. It Suggests That You Are Living Beyond Your Means
The need to borrow from your savings is a red flag - a warning that you are living beyond your means. When you can't find any other way to fund your lifestyle than by taking money from your future, it's time for a serious re-evaluation of your spending habits. What purchase could possibly be so important that you are willing to put your future in jeopardy and go into debt in order to get it? (For more insight, see Digging Out Of Personal Debt and The Beauty Of Budgeting.)
8. It Violates The Golden Rule of Personal Finance
"Pay yourself first" is the golden rule of personal finance. Violating that rule is never a good idea.
If the idea of taking a loan from you 401(k) plan crosses you mind, stop and think before you act. Instead of short-changing your future to finance your lifestyle today, consider re-evaluating your current lifestyle instead. Scaling back on your expenses will not only reduce the burden on your wallet, but will increase the odds that a sound retirement nest egg will be waiting for you in the future.
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