- Posted by Patrick Fisk, CFP®
- On October 26, 2020
Most people are worried about money right now, and millions are having trouble paying their bills. Even if you still have your job, it’s possible your partner or spouse does not.
When cash is short, it’s tempting to make a beeline to the savings in your 401(k), but I would strongly recommend against it. I’ve been advising for 10 years, and I understand that if you’re at the point where you are considering borrowing from your retirement account(s), you might think you have no other choice, but that decision has some not-very-well-understood (but substantial) consequences.
Here are 7 reasons why your 401(k) needs to be protected at almost any cost.
The cost of lost opportunity
When you borrow from your 401(k), the amount you withdraw will no longer be earning an investment return. If your 401(k) typically averages an 8 percent annual return, that means you are losing out (Opportunity Cost) on thousands of dollars each year.
That’s an expensive loan.
Repayment isn’t a 1-to-1 ratio
When you borrow from your 401(k), while you are borrowing from yourself, repayment isn’t anywhere near a dollar-for-dollar exchange. That’s because you built your 401(k) with pre-tax money, but you pay it back with after tax money.
Here’s an example: If you’re in, say, the 32 percent tax bracket, that means that for each $1 you get paid, you only have $.68 left over for repayment. In a sense, to repay each $1 you borrow, you must work 32 percent more than you did to build that account up in the first place.
It’s likely you’ll contribute less to your 401(k) while repaying a loan
What I typically see with folks who take loans from their 401(k) is that the money they were contributing before the loan is now devoted to repayment of the loan.
Let’s say each month you put 10% of your pretax income into your 401(k). If you take a loan, those loan repayment amounts, coupled with your usual 10% pre-tax contribution, might combine to total too much lost take home pay for you (especially if one spouse is out of work) to keep contributing. My experience has been that most of the people who take a loan end up adjusting their contributions down.
And, even if you can afford to continue to contribute, some 401(k) plans have a provision that won’t allow you to make contributions until after everything you’ve borrowed is repaid.
You’re risking your retirement
Your 401(k) is intended to help pay for retirement. But did you know that, due to poor health, or to care for a loved one, 50 percent of all people are forced to retire earlier than planned?1 Simply, you may not have as much time left in your working and earning life as you might believe, and that makes taking a loan on your 401(k) a risk you should avoid. Your 401(k) is almost certainly your largest retirement savings vehicle. If you have a big loan balance, and you are forced to retire, those assets won’t be there when you really need them.
If you can’t pay the loan back, it becomes a withdrawal
This is where things get messy (and expensive).
According to the Wharton Pension Research Council, 10 percent of people who take a loan from their 401(k) are never able to pay it back, meaning the loan becomes a withdrawal. That makes the loan amount subject to a tax bill at your regular income tax rate, plus, for those people under 59½, you’ll be hit with an additional 10 percent early withdrawal penalty.
If you lose your job, the repayment schedule resets
If you permanently lose your job (or you quit), and you have an outstanding balance on a loan from your 401(k), you’ll only have until your next federal tax return is due to repay the full amount (and not the five years that most plans allow).
Obviously, most people who are considering borrowing from their 401(k) don’t have $20,000, $30,000, or $50,000 lying around to pay off the loan in a lump sum.
It’s your “last resort” emergency fund and it’s legally protected from creditors
While some people might have absolutely no other choice but to tap their 401(k) in an emergency, every other option, including home equity lines of credit, second mortgages, other types of loans, even using your health savings account, every possible option should be evaluated with your advisor before making such an important (and far reaching) move.
Bankruptcies are on the rise, and while I certainly hope it doesn’t get to that, it’s important to remember that your 401(k) is protected from creditors (while your other savings and many of your assets aren’t).
That alone should give you pause about borrowing from your retirement instead of from a bank.
In closing, trying to determine where to find money in an emergency is stressful because you feel like your back’s up against the wall. Which is why having an Emergency Fund is so important, but that’s another conversation. You may have heard this before, but it bears repeating: You are not alone. There are millions of people in the same situation. What’s key is to not make any mistakes that make your circumstances better today, but worse tomorrow.
Probably the single most important job I have as an advisor is helping my clients make dispassionate and well-thought out decisions about debt and money. Realizing that’s where my greatest contributions are, should go a long way toward helping you understand the importance of having access to fiduciary financial advice that helps you get through difficult economic stretches like these.
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Over 30 years ago, the pilot-founders of RAA saw the need to provide highly specialized financial services to their colleagues in the airline community. At the time, there were many financial advisory firms to choose from, but none that focused on the unique needs, desires, and challenges that come with a life spent flying the line. Serving our friends and colleagues in the airline community is why we are in this business, but how we carry on this legacy is just as important. Turbulent times such as this are when we feel we can add the most value and we’re here to answer any questions you have.
1 AARP, New Study Finds Many Older Workers Forced Out of Jobs
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