2691: Is It Ever OK To Borrow From Your 401K? by Mark Dennis of Financial Finesse on Retirement Planning

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[00:01:10] This is Optimal Finance Daily, episode 2691.

[00:01:14] Is it ever okay to borrow from your 401k?

[00:01:17] By Mark Dennis of FinancialFaness.com.

[00:01:20] And I'm your host and personal finance enthusiast, Diana Merriam.

[00:01:24] Welcome back to Optimal Finance Daily, where every day I read and offer commentary

[00:01:29] on some of the best personal finance blogs on the web in about 10 minutes or less.

[00:01:33] So with that, let's get right to it as we optimize your life.

[00:01:41] Is it ever okay to borrow from your 401k?

[00:01:44] By Mark Dennis of FinancialFaness.com.

[00:01:48] Ideally, never, or at least rarely.

[00:01:52] Plundering or retirement piggy banks can be tempting when a financial emergency arises,

[00:01:57] or perhaps when we're looking for cash to finance a home purchase

[00:02:00] or pay off some high-interest credit cards.

[00:02:03] Although the IRS rules do allow for retirement plan loans,

[00:02:07] the maximum loan size is either 1. the greater of $10,000

[00:02:12] or half of your vested 401k balance,

[00:02:15] or 2. $50,000, whichever is smaller.

[00:02:19] While borrowing from yourself in this way can be convenient and seem relatively harmless,

[00:02:24] this type of short-term fix may have some long-term consequences

[00:02:28] that are more expensive than we realize.

[00:02:31] 401k loans seem attractive at first.

[00:02:35] On the one hand, borrowing from our company retirement plans is tempting for several reasons.

[00:02:40] No credit check is required, and consequently, it will not affect your credit score.

[00:02:45] The interest rate is potentially lower than that of a traditional loan.

[00:02:49] You pay back the loan conveniently through payroll deduction

[00:02:53] and you're borrowing your own money and paying yourself back with interest.

[00:02:57] Where's the harm, right?

[00:02:59] Then things can get ugly.

[00:03:01] A closer examination of exactly how all of the moving parts work

[00:03:05] as well as some of the things that could potentially go wrong

[00:03:08] might lead you to conclude that getting a bank loan,

[00:03:11] borrowing against home equity, selling other assets

[00:03:14] or even borrowing from family might be better for you in the long run.

[00:03:18] Here are some of the reasons to think twice before taking out a 401k loan.

[00:03:23] Number one, you'll pay taxes on the same money twice.

[00:03:27] It's true that you pay yourself back with some interest,

[00:03:30] but you also use after-tax dollars to make those interest payments.

[00:03:34] In the future, when you spend your pre-tax 401k money in retirement,

[00:03:39] those future interest distributions will be taxable as ordinary income,

[00:03:43] meaning you actually pay taxes twice on that money.

[00:03:47] Number two, lost growth and compounding.

[00:03:51] The money you borrow from your 401k is temporarily removed from the underlying investments,

[00:03:56] missing out on any market growth, interest, dividends, etc.

[00:04:01] The double whammy comes from the missed opportunity for this growth

[00:04:04] to be reinvested and earn even more through compounding,

[00:04:08] which is the financial superpower that comes from investing

[00:04:11] and staying invested over time.

[00:04:14] Number three, treating your 401k like an ATM.

[00:04:18] Once you dip into your retirement stash

[00:04:20] and use it to relieve some type of financial pain,

[00:04:23] you can begin to slide down a slippery financial behavior slope.

[00:04:27] Having rewarded yourself once with a relatively easy source of cash,

[00:04:31] you run the risk of training your brain to think of the strategy

[00:04:35] as a reasonable substitute for creating and maintaining better financial habits,

[00:04:40] such as regularly saving cash in an emergency fund,

[00:04:43] sticking with a budget, or increasing your retirement plan contribution rate.

[00:04:48] Staying faithful to healthier financial priorities

[00:04:51] helps you avoid disturbing your retirement plan's progress

[00:04:54] by treating it like an ATM machine and dipping into it multiple times.

[00:05:00] Number four, less take-home pay.

[00:05:03] While you're repaying your loan,

[00:05:05] your paycheck will be reduced by the amount of the loan repayment.

[00:05:09] If your cash flow is tight before rating your retirement fund,

[00:05:12] you may soon discover that it becomes even more challenging

[00:05:15] with a reduced paycheck.

[00:05:17] And number five, severe taxes and penalties.

[00:05:21] If you leave your employer for any reason,

[00:05:24] whether it's your idea or if your employer fires you,

[00:05:27] you might have to repay the entire remaining loan balance

[00:05:30] within as little as 60 to 90 days.

[00:05:33] This requirement varies from plan to plan.

[00:05:35] Some company retirement plans allow you to continue

[00:05:37] making the scheduled loan payments

[00:05:39] without having to pay it all back early.

[00:05:41] However, your payments obviously will no longer come from payroll deduction

[00:05:45] once your job ends.

[00:05:47] If your period of unemployment is lengthy,

[00:05:50] you might not be able to keep up with the required repayment schedule.

[00:05:54] Once you default on a 401k loan,

[00:05:56] the IRS then treats any remaining balance as a taxable distribution.

[00:06:01] If you're under age 59 and a half at that time,

[00:06:04] there may be an additional 10% tax penalty

[00:06:07] for taking an early withdrawal from your retirement plan.

[00:06:10] What was once a temporary financial fix

[00:06:13] could quickly become an expensive tax bomb.

[00:06:16] It might be okay to borrow once, if...

[00:06:20] Number one, you have a high interest rate.

[00:06:23] Think double digit debt and you have exhausted

[00:06:25] all other options to refinance

[00:06:27] or negotiate a lower interest rate.

[00:06:29] The ongoing challenge will be to reduce any temptation

[00:06:32] to begin using the same high interest credit cards

[00:06:35] or loan sources again and recreate the problem.

[00:06:39] Once you pay back the 401k loan,

[00:06:41] take that monthly loan payment you were making

[00:06:43] and redirect it to a savings account at your bank,

[00:06:46] building up an emergency fund you can use

[00:06:48] for future financial emergencies

[00:06:50] rather than raiding your retirement plan like a pirate.

[00:06:54] Number two, you owe the IRS back taxes.

[00:06:58] With interest and penalties stacking up on overdue taxes,

[00:07:01] this financial burden can become very serious over time.

[00:07:05] In this case, a 401k loan might be your saving grace.

[00:07:08] However, you may qualify for relief under the IRS guidelines

[00:07:12] for alternate payment plans and hardship.

[00:07:15] Number three, you're in real danger of defaulting

[00:07:18] on a student loan.

[00:07:19] In most cases, bankruptcy is not an option for these.

[00:07:23] Or number four, you're facing eminent bankruptcy

[00:07:26] or eviction from your home.

[00:07:29] Talk to a nonprofit consumer credit counselor

[00:07:32] at nfcc.org about alternatives to bankruptcy.

[00:07:36] If a 401k loan can buy you some valuable time

[00:07:39] while you restructure your cash flow and other investments

[00:07:42] to support a sustainable strategy

[00:07:44] and repay your 401k loan,

[00:07:46] this might be an appropriate financial move.

[00:07:49] The important thing to keep in mind

[00:07:51] regarding loans from your retirement plan

[00:07:53] is to make sure you address the underlying need for cash

[00:07:56] rather than simply assuming the 401k loan

[00:07:59] will solve the immediate problem.

[00:08:01] Otherwise, you could find yourself on an unhealthy financial treadmill

[00:08:05] where you repeatedly borrow from your 401k

[00:08:08] and begin to seriously jeopardize your ability to retire on time,

[00:08:11] comfortably or both.

[00:08:14] A good way to see just how damaging and expensive

[00:08:16] a retirement plan loan can be to your financial future

[00:08:19] is to use the National Center for Policy Analysis

[00:08:23] 401k borrowing calculator.

[00:08:26] This calculator shows how much less money you may have

[00:08:29] for retirement if you borrow from your retirement plan

[00:08:32] versus not taking out a 401k loan.

[00:08:35] Bottom line, make sure you have carefully considered

[00:08:38] all other alternatives before you undo

[00:08:41] much of the hard work you've already invested

[00:08:43] in growing your retirement nest egg.

[00:08:49] You just listened to the post titled

[00:08:51] Is it ever okay to borrow from your 401k?

[00:08:54] By Mark Dennis of FinancialFaness.com

[00:08:57] and I'll be right back with my commentary.

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[00:11:07] While I'm sure there are probably situations

[00:11:09] where a 401k loan is a good idea,

[00:11:11] I personally cannot think of even one.

[00:11:14] For me, taking on a 401k loan

[00:11:16] would require some pretty dire circumstances

[00:11:19] where I needed money immediately

[00:11:21] for some life-threatening emergency.

[00:11:23] I had no other reserves,

[00:11:25] no options for increasing my income,

[00:11:27] I didn't qualify for any other type of low interest debt

[00:11:30] and no one on the planet was willing to lend me some money.

[00:11:33] I can't imagine why I would need a loan so bad

[00:11:36] that I would risk my retirement savings

[00:11:38] and that I'd be willing to interrupt my money earning more money.

[00:11:42] I mostly hear of people taking a 401k loan

[00:11:45] to funded down payment on a house,

[00:11:47] do home improvements or consolidate debt.

[00:11:50] That sounds ludicrous to me.

[00:11:52] When I invest my money, I do it for the long term

[00:11:55] and I'm so firm in my commitment

[00:11:57] to not touch the money I have invested

[00:11:59] I actually think of it as a tax I've paid to my future self.

[00:12:02] That money is gone.

[00:12:04] I have no claim to it because it's not my money.

[00:12:07] It's future Diana's money and she says no anytime I ask for some.

[00:12:11] That should do it for today.

[00:12:13] Have a happy rest of your day

[00:12:14] and I'll see you on the Monday show tomorrow

[00:12:16] where your optimal life awaits.