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If you take money out of your
401k to pay off your debts, you may regret it later. Taking out
a loan or an early withdrawal will reduce your eventual retirement
account and may force you to work longer.
By taking money out of your 401k
account, you reduce the benefits of tax-free compounding that are
key to building up a substantial balance. Experts recommend trying
other alternatives first, including lifestyle changes to reduce
your spending.
This is especially true if your
employer matches your contributions. In order to get the maximum
benefit from your 401k, you should always contribute enough to
get the maximum employer match.
If you face a real emergency, and
have no other safety net, it's acceptable to tap into your 401k
plan, financial planners say. But if your problem is that you are
living beyond your means and need to pay back your creditors,
watch out. You could be paying your way right out of a secure
retirement.
Just over half of all 401k plans
make loans available to employees, according to the Employee
Benefit Research Institute (EBRI). This is seen as an incentive to
get employees to participate in the plans, because they are more
likely to sock money away if they know they will be able to access
it in an emergency.
But you should really think of your
401k as off-limits until retirement. Don't use it as a safety
net. You can set up other vehicles for forced savings that will
enable you to get at your money without penalties. For example,
you can have your bank automatically take money from your checking
account each month and deposit it in a money market account.
According to the EBRI, individuals
between 30 and 59 years old are the most likely to take out 401k
loans.
For younger people, retirement may
seem a long way off, but remember that when you retire you want to
live off your savings. You don't want to start working again at
age 75! Since the amount you'll receive from Social Security
probably won't be enough to sustain your lifestyle, your 401k
balance is vital to your retirement happiness.
Taking out a loan can have a big
effect...
Taking out a loan on your 401k can have a drastic effect on your
eventual balance at retirement if you stop contributing to the
account while you are paying back the loan.
Here is a hypothetical example of
what a loan can do to your retirement savings. Say a participant
(George) is 35 years old, earns $40,000 a year, and has a 401k
balance of $20,000. He contributes $2,400 a year (6% of his
salary), and his employer match is $1,200 (3%). Assume he gets an
annual return of 8% on his account. If he continues saving at this
rate until age 65, his nest egg will be about $583,723. (This is
assuming all factors remain constant.)
But George wants a new car. He
could afford a compact, but he decides that an extra $10,000 will
let him get the Sport Utility Vehicle he wants. He takes out a
$10,000 loan on his 401k and pays it back over five years, at an
interest rate of 5%. He can't afford to continue making his
contributions while he is paying back the loan, though. When he
reaches age 65 his account will be worth $458,673.
That difference of roughly $127,000
in principal translates into a loss of $7,620 a year in retirement
income, assuming a rate of return of 6%. That's about $630 a month
- quite a chunk of cash.
Consider this. Elizabeth Allen, a
Certified Financial Planner in Michigan, has a client who at 71
years old was forced to get a part-time job to make up only a $100
shortfall in her monthly income. "There was nothing we could
cut from her budget. The only way for her to live was to earn that
$100."
In George's case, he could have
minimized the negative effects if he had continued contributing to
his 401k in addition to paying back the loan. In that case, he
would have ended up with $578,275 in principal, or a shortfall of
just $5,000.
So, if you absolutely have to
borrow from your 401k plan, make sure you pay the loan back as
quickly as possible, and continue to make contributions to the
plan in addition to the loan payments.
Another point that is often
overlooked is that you will be taxed twice on the loan amount. The
money you borrow is money that you contributed before taxes. But
you pay it back with after-tax money (unlike your contributions,
it is not deducted from your paycheck before taxes). When you
withdraw the money at retirement it will be taxed again.
...But taking an early distribution
could be even worse! Say George decided simply to withdraw the
$10,000. (He could do this if he were changing jobs, for example.
But remember, if you are still working for the same employer you
can only take an early distribution in a hardship case.)
The problem is, he would have to
pay about 50% in taxes and penalties, so he would actually have to
withdraw $20,000 in order to get $10,000 cash. That means starting
over with the 401k, and a further reduction in the balance at
retirement.
How's Your Spending Behavior?
Calculators available on the Internet that seem to give a simple
answer about whether you should take a loan on your 401k don't
necessarily tell the whole story because they cannot take into
account one huge variable -- your spending habits.
Here's a story related by Ms. Allen
about one of her clients. The 50-year-old woman cashed out her
entire $125,000 account to pay off her credit card debt and that
of her two daughters, as well as to put a down payment on a home.
She only saw about $62,000 of the money however - the rest went to
the IRS and the state of Michigan.
Now, says Ms. Allen, a year later,
this person has run up more credit card debt - only this time she
doesn't have her 401k to bail her out. She has taken on a second
job. "She'll be working for the rest of her life, and that's
sad."
This case, while extreme,
illustrates the problem with using money earmarked for retirement
to take care of immediate needs. Once it's gone, it's gone. Also,
many people overlook the fact that 401k money is the only money
you have that is protected from your creditors. They can't touch
it, even if you declare bankruptcy.
Before you mortgage your retirement
(and possibly commit yourself to a life sentence of work) you
should look at every other possibility for reducing debt - a home
equity loan, debt consolidation, even taking out a second mortgage
on your home, experts say.
Even if you end up losing your
home, it won't be as bad as ending up without retirement income,
says Russell Hall, a CFP in Wichita, Kansas. "You can
probably get another home. The worst thing is to lose your
retirement future."
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