I was speaking today with a young lady who is going through financial difficulty. With the way that our economy is going, I’m sure that isn’t surprising news. However, it was one of her proposed “solutions” that caught my attention.
Her plan to get out of her immediate situation is to take money out of her 403b retirement plan! For those who are not familiar with this type of investment vehicle, a 403b is an employee-sponsored retirement plan, that is very similar to a 401k. However, a 403b will only be offered by a non-profit organization (such as a school, university, or hospital).
Unfortunately, I didn’t have a lot of time to talk to her and explain why that is generally a bad idea. I guess that’s the great thing about being able to write online, I can just send her the link to this post 
! Because they are much more common, and many people are considering this line of action, I am going to discuss the dangers of borrowing money from a 401k.
Should You Borrow From Your 401k To Pay Off Debt?
Many 401k plans will allow you to take out a loan while you are still working for the company. Not only do most plan administrators make the process of borrowing from your 401k easy, but many people have even been convinced that borrowing from their 401k was a smart move because they would just be “borrowing from themselves”.
I know people who have taken out tens of thousands of dollars out of their 401k’s, and have justified it by applying the “I’m just borrowing from myself” logic. Whether they took out the money in order to pay off debt, or simply buy some expensive new toy (or house), it seemed like a harmless thing to do. If they are just paying themselves back with interest, then it’s a “win-win” situation!
This may seem like a good idea at first, but their are a couple of things to consider before making this move. First, the money that you save in your 401k is for retirement! The point of this and other retirement accounts is for you to deposit money (up to the annual 401k contribution limits) into particular funds, and give them time to grow.
Time is the most important factor when it comes to investing, and by taking out a loan from your 401k, you lose time.
When you borrow money, you remove that balance from your retirement account, and it fails to earn interest (or other forms of gains). Not only do you lose that interest, but you also lose the chance for that interest to be added to your principal amount, and gain more interest! This compounding effect is completely missed when you take money out of your account.
So, the first thing that you lost when you borrow money from your 401k is all of the potential interest, dividends, and capital gains that would have been earned based on your investments. The second thing that happens is that you lose the benefit of compounding – where all of your gains are added to your investment principal, and then earn “gains” themselves.
How severe the impact is dependent on how you choose to attack your debt. Basically, you have three options when it comes to your 401k and the decision to pay off debt:
First, you can choose not to make any changes to your contribution levels.You continue to fund your retirement as normal, and try to find the extra money some other way.
Second, you can reduce or completely removing the amount you contribute. In this scenario, your retirement fund stays in tact, and it might even grow based on how much you reduce your contributions.
The last option is to completely dismantle your 401k, or at least cripple it, buy removing all or some of the money you have stashed away. The second option is worse than the first, but this third option (the one that people try to rationalize), is the most detrimental. Not only are you stopping progress, and losing compounding effects, but you are actually going backwards, by reducing the amount that you have saved for retirement.
You shouldn’t try to comfort yourself in the fact that as you pay back the loan, it’s all going back toward your retirement. But instead, you should be angry at all of the growth that you are missing out on, because you destroyed, or significantly reduced the size of, your retirement account. For as long as our money is not in our retirement account, we miss out on all the gains on that money, as well as the added returns on those gains!
Also, many jobs (or plan administrators) will require that you pay back the loan in full within 60 or 90 days of leaving the job. If you are not able to pay back the loan within that time, then you will have to pay taxes on the amount not repaid, as well as a 10% early withdrawal penalty! With the economy in the middle of a decade-long downturn, and more employers depending on the contingent workforce, it is not a good idea to put yourself in a position to have to repay a five-figure debt if you lose your job!
My advice would be the same whether you are talking about a current IRA or 401k, or even a retirement account from a former job.
Of course, there are times where it is best to take out a loan, but only in extreme cases. You should try to find ways to reduce your expenses, bring in more income, and seriously change your lifestyle. Only after you have exhausted all of these avenues should you even look at your retirement accounts!
photo by vichie81
{ 6 comments… read them below or add one }
One thing to keep in mind is that some IRA plans will impose a penalty for taking money out before you retire. For example, I wanted to do this with my Roth IRA and there was a 10% penalty fee for taking money out. If the interest I would pay on my loan if I hadn’t taken the money out accounted for more than these 10% then it’s a good deal. A great way to calculate that is by using the CNN debt planner.
I think it depends on your debt to savings ratio and how you expect inflation to affect both you debt and the investments in the retirement plan. Inflation could erode both values but at different rates depending on a few different factors.
I think never is way too strong of a word…if someone has a ton of debt at 20% and they can get a 401(k) loan at 5%…and are making the smart move of stop spending it may work out.
Much higher risk but high reward.
I totally agree with you. I hope to NEVER take any money from our retirement accounts. Too many people think this is a great idea, but it makes me sick just thinking about it. Great post!
Great article!There are a lot of short terms things to lessen the debt..
The short answer is never! Those funds are supposed to be long term savings. There are various shorter term things you can do to reduce debt. Reduce your spending is your first line of defense.