It is said that nothing is as certain as death and taxes, but everyone will at one time or the other experience a financial crunch too. Those are the moments when you need quick bailout cash which is not easy to come by, albeit affordably. If your bank account’s credit facility is stretched thin, you might want to avoid a high-interest rate personal loan, for instance.
Data shows that three in ten Americans in such circumstances dip their hands into their retirement kitty. The retirement piggy bank has become a go-to source of quick funds for footing medical emergencies, higher education requirements, or down mortgage payments.
More data shows that since the advent of the Great Recession, more and more households are utilizing their 401(k) facilities as sources of credit. As per the National Bureau of Economic Research findings, 20% of all 401(k) active participants have a loan taken out on the facility at any given month.
Their data also shows that the age group between 35 years to 44 years is more likely to borrow from their retirement kitty than other age groups. This, however, does not come as a surprise because as per a Pew Charitable Trust survey, at least 60% of all households in the U.S go through a financial crunch in a year.
This is often caused by unforeseen events such as death, illness, injury, unemployment, vehicle repair, or significant home renovations. Unfortunately, most households live paycheck to paycheck, and only 40% of these households have enough squirreled away to cover a $1,000 emergency expense.
So, should you really break open that piggy bank?
Borrowing from your 401(k) plan is often ill-advised. You might be thinking that you are 20 years away from retirement and therefore you have enough time to pay the cashback. Most 401(k) providers also make it almost too easy to get some funds off the money stuffed piggy bank.
You are, for instance, allowed up to $50,000 or half of your balance as credit. The providers will also not rush you to payments, giving you five years to repay the amount borrowed. If you are using the amount borrowed to pay off your first home, you will even a more extended repayment period.
The providers also will hardly do a credit check since you are basically borrowing from yourself. This makes this credit line suitable for those moments when you are extreme financial duress. If for instance you are about to lose your home or your heater goes bust in winter, then such a grant will be a welcome relief. However, such situations are rare, and below are a few of them.
Instances when borrowing from a 401(k) plan works
- For home purchases
Say you have done your footwork, and you have your dream home insight. To sweeten the deal, the home purchase agreement is too good to pass up, and you, consequently, need a down payment fast to ink the deal. If you have a weak credit score, a 401(k) loan will be your easy way out. It will afford you a large enough amount to pay up the down payment and keep your $3000 personal loan interest rate low taken for new home.
- For medical emergencies
If you have a high insurance deductible health care policy, then $7,000 for emergency surgery or health care for critical illnesses will be a most welcome relief.
- For high-interest debt payoffs
If you have been negligent about the use of your credit card and are up to the neck in high-interest debt, then a 401(k) loan can offer some relief. With it, you can repay that plastic money debt in full and keep your credit rating clean.
- For higher education
Like most people, you are probably on the perpetual hunt waiting for your dream job. Therefore, any ladder to help you boost your chances of such an opportunity must be met with open arms. Opportunities for attending graduate school can help you climb up the career ladder, and a 401(k) grant is one easy way to foot the bill rather than an expensive student loan.
- For IRS trouble
Anyone with IRS arrears and back taxes will tell you how difficult it is to rest easy. However, a 401(k) credit can give you a clean slate and ensure that you are all legal.
Reasons not to break that piggy bank
While a 401(k) does seem like an easy way out of a fiscal quandary, most financial advisors strongly advise against it. By its nature, the 401(k) is designed as the ultimate investment vehicle. All the money you channel towards it is not taxed until when it is ripe for withdrawal at retirement. This leaves you with more money to compound in the long term.
Many 401(k) s are also employer-matched at least to a certain percentage. This gives you a lot of free money for your sunset years. What’s more? The amount saved is automatically hived off your paycheck every month, which provides you with many psychological benefits.
, however, as per the law should not be withdrawn before you are 59 1/2. If you have to access the funds before this age, then, you are liable for a 10% tax from the government. This is the 401(k) loan monkey’s paw.
The cost of dipping your hands into your retirement funds will not only slow down your retirement savings goals but will also cause double taxation of your savings. It is therefore paramount that if you have to borrow from the 401(k) that you borrow very wisely.
Why? Once the money is out of the retirement account, you begin to lose any value you once had from compound interest. You will also have to pay it back with interest to make a compensation for the losses gained.
Disadvantages of borrowing from your 401(k)
- It halts your savings goals
Some of these plan providers will stop you from making any additional payments to your account until all grants are repaid. And even if you could keep contributing, you are now paying off a loan which reduces your chances of making sizeable contributions. If you cannot use your 401(k) to save for your future, then your sunset years might be dark indeed.
- You lose money
First of all, the credit extended to you might halt your contributions as you repay it back. Secondly, the borrowed amount is not accruing any interest from the bond or stock markets. The most significant loss, nonetheless, is the opportunity cost. While the interest rate of the 401(k) loan is low, there are taxes paid on it. You, accordingly, will lose out more from the loss of growth of the borrowed funds.
- Time begins to work against you
Every long term investment has the benefits of time working on your behalf. Time makes money grow, and financial experts say that your long-term savings will double every eight years. If you, therefore, take out the money for debts, you lose on the doubling opportunity.
You are also left to struggle with lost contributions and lack of more growth windows. You will, hence, have less at hand at retirement than you would have had you keep your hands off the piggy bank.
- You could get yourself into worse financial situations and lose more cash
Say you have your 401(k) loan at hand but are unable to service it. What happens? The balance will be classified as a withdrawal and will be subject to income taxes. Remember that you are still liable for a 10% penalty if you took out the cash before the age of 59 1/2. So unless you can access an exception such as a post-55 exception avoid the grant at all costs.
- You become trapped
If you decide to go for the retirement fund debt, you are expected to pay it all back immediately you quit your job. If not, taxation and penalties kick in. This implies that so long you have a debt of this kind, you are stuck in a job you might not like for some time. If something better comes up, you might need to pass it up, unless you are willing to shoulder the penalties.
- You become a violator of the golden rule of personal finance
The very first rule of personal money management is to pay yourself first. You do this by saving for the future. Violating this rule is a red flag that you are living beyond your means. You, therefore, need to evaluate your finances and find out where it is you have bitten more than you can chew. There is little in terms of purchases that make more sense than saving up for your golden years.
The bottom line
If you are thinking of taking out that 401(k) loan, stop and think about your action first. Reevaluate your lifestyle and scale back on spending. You might find out that you really do not need to touch that nest egg after all.