Borrowing From Your 401(k): A Financial Sin

When we put money into our retirement accounts we do so for a specific purpose: retirement.  All the money you have funneled into your 401(k) is supposed to buy you that dream retirement lifestyle you spent your entire life working toward.  But unfortunately, more and more people are finding that life can throw them curveballs that, in turn, can throw off their financial plan.  Often times, when people find themselves in a financial bind, they find it hard to ignore that shiny apple hanging in front of them in the form of their 401(k).

Far too often people are reaching out to pick that apple and borrow money from their 401(k).  The reasons for their need varies from home purchases, to their kid’s college tuition, to a myriad of other financial emergencies.  Most people who make this move know that it’s a “forbidden” action, but what many people don’t understand is why.  What is the danger in picking that apple and borrowing money from your 401(k)?  If more people knew the consequences, it would be hard to believe that many of them would make the same decision.

So what’s the big deal about borrowing from your 401(k)?  What are those consequences that your financial advisor seems so concerned about?  Here are just a few.

●     Paying back means you’re not paying in- After you borrow from your 401(k), what you would have contributed to add to your funds now will go towards simply trying to pay back what you took.  Anyone planning for retirement understands the power of time in terms of compounding your money.  That is what is driving your growth.  If you stop paying in and adding to your total, you lose out on all of that potential growth.

●     Tax Trap- When you pay back a loan from your 401(k) you do so with after-tax money.  When you retire, and take this money out later, it gets taxed again like the rest of your 401(k) contributions.  Essential this means you are paying a tax twice for that single amount of money, both as your pay it back now and as you take it out later.

●     Job Insecurity = Loan Insecurity-  When you borrow from your 401(k) you typically have a set time period to pay it back, usually within five years.  This may seem acceptable, but this changes if you leave your current employer.  If, for any reason you stop working for that company, you could be forced to pay back the loan much sooner, possibly in as little as 30 days.  If that new, incredibly abbreviated time frame isn’t possible for you, you will make up the difference in penalties and fees.

●     Creditor Vulnerability- When your money is inside of your 401(k) it is in something of a safe-haven from creditors.  They are unable to touch it.  This changes as soon as you pull any money out of that plan.  At that point, whatever you took out is now fair game for any creditors to go after.

●     Short Term Solution- In many cases, borrowing from your 401(k) is like using a band-aid to cover a bullet wound.  If you are in a position where you don’t have the funds to cover your bills, for example your mortgage payments, pulling money from your 401(k) will only stall the inevitable.  It isn’t a long term solution and it doesn’t give you plan to create a long term solution.  Not only does it delay the growth of your retirement finances, but it often times will leave you just as injured as you were before.

So despite the fact that your 401(k) might look like the perfect solution to a financial shortage, the consequences might be harsher than you know.  If you layout all the effects of picking that forbidden fruit you might think twice before you take a bite out of the apple of your future.