According to recent 2018 figures from Fidelity Investments, one in five workers has a loan against their 401(k) plan. From financing a down payment on a home purchase, paying off credit card debt, or covering a major financial emergency like an illness or job loss, borrowers are funding many of life’s expenses as a quick fix while risking their future retirement plans.
Tempting as it may be to borrow against your 401(k), treating your retirement savings like a piggy bank every time you need quick cash is not a wise financial move. Simply put, borrowing from your retirement account risks your future retirement plan.
Although borrowing against your retirement plan may seem like a quick, easy fix to today’s financial problem, especially since it requires no credit approval, the real costs are rarely considered.
Here are four reasons why you should NOT borrow against your 401k or another retirement plan:
- During repayment of the loan, you’re likely to reduce or stop contributions altogether losing out on years of contributions and growth potential.
- The “I’m paying myself back” rationale isn’t as reasonable as you may think. Sure, you’ll pay yourself back with interest. However, when you consider that your repayments are partially after-tax dollars, that will later be taxed again upon withdrawal, this theory is not as equitable as it may seem at first.
- Borrowing has significant consequences should you lose your job or quit, or become unable to repay the loan. In many cases, unpaid 401(k) loans are subject to penalties and taxes.
- If you borrow against your 401(k) loan once, you’re likely to do it again.
Clearly, the real costs of borrowing against your retirement account are penalties and lost opportunity for growth. Consequently, these loans should not be your first option when a financial need – or a financial emergency arises.
So then, what can you do to avoid the temptation to borrow against your 401(k)?
Have an emergency fund of three to six months totaling a typical month of expenses set aside, before contributing to your 401(k) or another retirement account. If saving for an emergency is tough, join a savings challenge, find stuff to sell, or take on a side-hustle to kick-start your emergency fund. Start with a smaller goal of $1,000, to begin with, and remember that saving, much like frivolous spending, is a behavior.
Life as we know it is full of surprises, many of which result in financial emergencies. That’s why it’s so important to plan for tomorrow and the future. Be prepared when the next financial emergency happens – have an emergency fund in place. This way, your future retirement plan will be there when you need it most – at retirement.
To weigh the pros and cons of taking out a 401(k) loan, visit the Financial Industry Regulatory Authority (FINRA) for more information.
Sign up for the Center for Financial Health’s Money Challenge to learn how to adopt behaviors that encourage saving for a rainy day.
Denise Keiser is a leader, mentor, and trainer specializing in money and housing with 20 years of experience in real estate and finance. She is seen on TV as the “Money Expert” for WLNS-6 Lansing’s “Money Monday” where she provides weekly money tips. Denise currently serves as the executive director of the Center for Financial Health, a Lansing-based nonprofit that inspires a lifelong commitment to financial wellness.