Financial Literacy

There are three different ways in which borrowing money from your 401(k) is a very big financial mistake. There is no reason to borrow from this account that is worth the three types of financial downsides that are listed below.

I The actual results for people who borrow:

1. People who borrow from their 401(k) usually stop making contributions to their 401(k), or sharply reduce them. So not only have you reduced your 401(k) balance, you’ve stopped the contributions, the most important driver to reach your retirement goals.
2. Any loan from a 401(k) is due within 60 days if you leave or lose the job for any reason. Few people can repay in this time period and so the IRS declares the loan an early-retirement distribution. This means you are charged a tax penalty of 10% on the money you withdrew. Again, many people do not set this money aside from the loaned amount and so they owe interest and penalties on the withdrawal that they cannot pay.

II The financial mechanics to your income and net worth:

1. In order to make interest and principal payments, you earn money and are taxed on it once. What remains is after-tax income. This after-tax income is then used to repay the loan, which moves the money into a pre-tax account, an account that has not been taxed yet. So, once you are in retirement and withdrawing money from your 401(k), you are taxed on all of the money at high ordinary-income tax rates. This means you are paying income tax twice on any loan repayment to your 401(k).
2. When you borrow money out of your 401(k), you are missing out on any potential investment growth during the loan period. This is defeating the only reason that you have money in a 401(k), for investment growth over time.

III You are mixing categories of money:

Money that is designated for your retirement money is actually for your retirement; not for a home repair, not a car, not college, and not for spending on anything else. When money is taken from savings or investments for a different purpose, it financially imperils the goals from where the money was taken. Unlike most other spending categories, there are no grants or subsidies for retirement; it is solely up to you and your contributions. If you fail to make contributions, or borrow money from retirement accounts, you are risking your capability to ever retire (at a time when most people are least able to work).

So what do you do instead of borrowing from your 401(k) when you really need the money? A few recommendations:

1. Immediately eliminate any extraneous expenses.
2. Act like you’re in high school and hustle for cash: cut grass, clean gutters, walk dogs, clean windows, run errands, tutoring – any service that you can perform this week with minimal marketing and supplies.
3. Dramatically reduce your housing costs, move to a cheaper living situation because housing is normally one of our largest expenses.
4. Implement a plan to earn more money: job search, getting certifications and other resume’ builders, network to expand your job search to other geographies/industries.
5. If you must borrow, try to get an unsecured loan with a low-interest rate. Just make certain that the interest and principal payments to pay back the loan are easily affordable to you. Otherwise, you are putting your finances into an even worse condition.
6. If you are interested in borrowing money from your 401(k), you are likely facing a serious financial challenge. How did this come about? How is it that you hadn’t saved or insured for this possibility? Is it really your responsibility? Whatever the reasons, you must learn from them to prevent them from occurring again. But more important, you must act immediately to address your situation using the previous suggestions.