I’ve been asked recently by someone if he should borrow from his 401(k) to fund the down payment of a new home. He had been given a myriad of different answers from people at work and finally came to me to hear the inevitable advice he was reluctant to hear- a resounding “No”. I know it was tempting for him to tap into the sizeable nest egg that he has accumulated, but here are the 3 reasons I gave to make him think twice before taking the leap:
1) Who really likes losing money?
The most common rationale used for taking out 401(k) loans is the “I’m paying back myself” excuse. Of course in theory this is true, but all you’re really doing is helping yourself today by hurting your 65 year old self who likely wants to be sitting on a beach rather than working into your 70’s. I understand that it’s easier to justify paying back yourself rather than a bank or credit card company but there are other financial repercussions to consider:
• Many 401(k) loans have a processing fee that can be anywhere between $50- $100. To put this into perspective, if you’re taking out a loan for $1,000 to pay off a credit card, you could be paying 5%- 10% to do so.
• The inevitable double taxation. When you pay back your loan, you are doing so with after-tax money. As the payments you make are made up of a combination of both principle (repayment) and interest (new contribution), you will be paying tax twice on the interest when a distribution is taken. So for all of you who hate paying taxes, the fact that a portion of your 401(k) will be taxed twice later in life might deter you from taking the loan.
• By withdrawing from your 401(k), you are missing out on the potential advantage of compounding interest. Compounding interest is when you earn interest not only on your original investment, but also on the interest it has already earned. At first your investment assets may grow slowly and then at greater speeds as the years go by. (This is assuming, of course, that you are invested properly and your investments within your 401(k) actually do grow over time.)
2) Taking out a 401(k) loan suggests you may be living beyond your means
Having to sacrifice the growth of your financial future for the need or desire of something today is the red flashing light that should trigger you to take stock of your current spending habits. We’ve all been told before that we should have an emergency reserve established which should be anywhere between 3-6 months of your living expenses and I can’t stress how important this is. This is the bucket that you should be tapping into before your 401(k).
There are numerous resources such as websites, online tools and books that can help teach you to organize your financial life but this is the guideline I use to make sure that my spending habits are in check:
• 50% Essential Expenses- No more than 50% of your take-home pay should be spent on housing, utilities, groceries and transportation.
• 20% Financial Priorities- At least 20% should be allocated towards your retirement, emergency reserve and any debt that you may have.
• 30% Lifestyle Choices- Here is where you can really re-evaluate your spending habits and see if there’s anything that you can generate some savings on. This category includes things like cable, clothes, gym fees, going out to dinner, hobbies and any other miscellaneous expenses.
3) You’re trapped
If you quit or lose your current job, any 401(k) loan outstanding must be paid back almost immediately. The consequence of being unable to do so is not only having the balance taxed at your current income rate but also a 10% penalty if you are under the age of 59½. This rule both rubs salt into an already open wound if you’ve lost your job and can also discourage you from seeking other higher paying opportunities. If you have taken out a loan, chances are that you have done so due to a financial hardship so having the available cash to repay it is probably not an option. Everyday life can be stressful enough, why make yourself susceptible to be at the mercy of your employment as well?
If you’re anything like me, besides the obvious of winning the lottery, early retirement is the next best dream. Before making the decision to borrow from your retirement, please make sure that you’ve done your research. Take the time to look at your current spending habits, research different loan options, use debt consolidation tools or consult with your financial advisor. Every alternative should be exhausted before encumbering the future of your financial freedom.
Megan McNeill serves as a Financial Advisor at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at mmcneill@strategicpoint.com.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Megan’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.