The Pitfalls of Borrowing From Your 401(k)

Many 401(k) holders don’t really know what a 401(k) is. They just understand that it’s a method by which they defer immediate financial gratification in exchange for having enough to live on during “retirement,” a concept so far in the future for most of us that it might as well be riding a hoverbike.

It’s important to understand that a 401(k) is an investment vehicle, not an emergency fund. Nor is it a vacation savings account, nor a Christmas petty cash envelope. The idea is to hold onto the money inside your 401(k) and let it snowball, month after month, until doing so becomes habit. Then, decades later, you’re enjoying something approaching affluence instead of eating cold soup out of tin cans. Withdrawing before you get there defeats the purpose. And there’s plenty of disincentive to withdraw early.

Allowed to Borrow

Some employers do let you borrow up to half the value of your 401(k). You have to pay back the loan in five years, and it’ll be restricted to medical expenses, education, home buying or stopping your home from getting foreclosed upon. Your employer has to pay to administer any loan you make, which is why they’re not going to let you use a loan to pay for a trip to Europe. Not that you would do that anyway. And if you borrow against your 401(k) and then lose your job, your 401(k) stays intact but you have to pay the loan back immediately. You know, because when you’re out of a job the first thing you want to do is have all your long-term bills instantly come due.

If you want to withdraw money before you turn 59.5, your 401(k) will literally be decimated. You’ll pay a crushing 10% penalty. Oh, and you’ll get to pay taxes on what you withdraw, too. Unless you’re withdrawing money for one of the above activities deemed acceptable by the Internal Revenue Service.

Loans from your 401(k) sound counterintuitive on the surface. Aren’t you really just borrowing from yourself? But this isn’t merely pulling money out of your right rear pocket and moving it to your left front. On some level, it’s reneging on an agreement. The agreement not to commingle the finances of your present self and your future self. If you’re committed to doing so, understand that you’re restricted to either half what you’ve amassed, or $50,000 – whichever is less.

Mark Twain said that man is distinguished from the animals not so much by his ability to reason, but by his ability to rationalize. In that spirit, many people blatantly use 401(k) savings to pay for junior’s college education. Never mind that a non-hard sciences degree is a notoriously poor investment, some parents can’t be swayed from the notion that a degree must be achieved at all costs. Including some costs, like 401(k) loans, that never should have been incurred in the first place.

Not Even to Buy a House

The same goes for home ownership, or foreclosure avoidance. If you’re thinking of tapping into retirement to buy a house, the arguments for not doing so are varied and ironclad. While owning a home is a laudable goal, and borrowing is probably necessary to achieve that goal, there are better places to borrow from. Particularly in 2011, when a static currency means that mortgage lenders are closing in on the theoretical minimum rate for fixed mortgages. Four percent is a better rate than the future you can offer the present you, and it won’t cut into your retirement, either.

If you already own a home, have missed multiple mortgage payments, and the only thing stopping the constable from evicting you is an emergency loan from your 401(k), cut off the finger to save the hand. There’s no sense in losing two necessities, your home and your future.

The Bottom Line

One of the first concepts freshman economics students learn is that of the price of money, better known as the interest rate. Money from a family member is relatively inexpensive, sometimes even free. Money from a loan shark can be the costliest you ever borrow. Not far behind that is money that erodes your retirement savings, and that comes with a federally mandated 10% penalty and a non-negotiable five-year term.

“The Pitfalls of Borrowing From Your 401k” was provided by Investopedia.com.