Borrowing from your Retirement Plan:
Paying a Penalty for Poor Planning
That seems to be the motto among Americans who are beginning to show signs of being stretched to the limits. This new You Owe You thinking or UOU is certainly not new. Folks who have fallen into financial dire straits have borrowed from savings and retirement funds since they were permitted to do so.
The reasons are many. Often confronted with a medical emergency, peoplehave taken money from all sorts of accounts. Unemployment can also be a catalyst for this type of borrowing. You can legally borrow from such accounts for college or first time home buying, but the practice doesn't make the action any less intelligent.
Borrowing from yourself, such as what borrowing from your 401(k) does not come with a penalty provided you pay the money back in a short time (often five years/fifteen years for a home purchase) and do so with the interest you agreed upon with the plan when you did so. But the penalty against what that money could have been in those retirement years does not make it worth the trouble.
401(k) plans are often easy to access, much more so than pensions or IRAs. And this accessibility makes this fund seem more like an ATM than a savings for some far off distant future. When you do borrow, almost of fourth of the money you withdraw will be lost. This means that money that could have been invested was not.
This penalty is especially bad when the economy is doing poorly and the markets are feeling the same sort of pain. The opportunity to keep that money invested (buying low with the same deduction is why dollar cost averaging, on of the mainstays of retirement saving and why 401(k) plans have reached the level of investment they have) is lost, taking money off the table just at the time when you would benefit the most. In all likelihood you will be selling shares that you probably paid a higher premium for when the economy and the markets were doing better, adding insult to injury so to speak.
These borrowing events can be tempting. Generally the interest rate you are charged is less than the current rate charged by a typical lender. The amount you can borrow is generally higher ($50,000 or half of what you have accumulated) and the payback terms seem custom made for just such crises.
The penalty for failing to repay the loan (remember you are borrowing your own money) can trigger a 10% excise tax and the money is then treated as real income, taxed at your rate.
There are three things you can do to avoid such occurrences.
Some emergencies are unavoidable. But failing to plan for some or them is not. Everyone with a job should be able to project a budget out one, three or six months down the road. Doing this will let you see which months are better for saving additional cash to offset these emergencies.
Two, increase your deduction when times are good (for you) and decrease it when times are tougher. Try to get at least the employer match. That is free money and should be taken at all costs.
Three, be resourceful. If you have made some bad financial decisions, your retirement income should not be used to get you back on track. It won't work and it is simply a quick fix, nothing more. Get a second job, cut back on all expenses, even it means living well-below your current level of comfort, and use every available agency or resource at your disposal. Researching these option before hand can save you hundreds, if not thousands of dollars.
It is true that life comes at you fast, but on the flip side, not all of the troubles that life is credited with are outside of your control. Make a plan early and stick with it. And if you borrow, be sure to set up a plan to pay it back once the ill-wind of fate blows over.
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