You’ve been hunting for weeks and have finally found your dream home in a neighborhood where you could spend years.
Additionally, you already know where you want to hang the Flat Screen TV and figured out the color scheme for throughout the home.
One problem: Where do you get your down payment? Immediately your thoughts go toward your 401 (k) plan right? Well before you call to withdraw, consider these reasons why you should never borrow from your 401(k) plan:
- Borrowing defeats the purpose of having a 401(k) account to begin with. The money is there for one main reason: To provide for your retirement. Regardless of how urgent you think your situation is, it will be quite a different experience when you’re in your 70s or 80s without any money. You need to find another solution for your present-day emergency issue.
- Compounding will be history. Taking money from your 401(k) means that you’re selling some of your investments. If they continue to go up in value, you won’t reap the profits and the compounding that goes along side them is gone.
- It will most likely be a sell low and buy high situation. As you pay back the loan, you’re repurchasing the previously sold shares— but at present (and most likely higher) prices.
- Expect to be charged added interest and fees. Most plans charge an origination fee regardless of loan size, and this goes straight to the administrator— instead of being returned to your account.
- Contributions could be halted. Many plans won’t even let you contribute to a 401(k) until you’ve paid off any and all loans. In some cases that might come down to years, during which at this time, you’ve lost the advantage of reducing your taxable income.
- Paychecks will be reduced. Most plans require you to start repaying your loan by automatic paycheck deductions starting with your next paycheck. This means your take-home pay is cut, possibly by more than the amount you were contributing to the plan prior. Keep in mind, this repayment isn’t tax-deferred; so your taxes could rise, lowering your net pay even further.
- Skipping to repay by the deadline could red flag a tax risk. Most 401(k) plan loans must be repaid within five years. If you renege, your employer will consider the loan balance as a distribution, triggering income taxes and the 10 percent early withdrawal penalty if you’re under age 59½. You could also be forced out of your plan and prevented from contributing in the distant future.
- Additional risk if you quit or get fired and lose your job. If you leave your employer, the loan will be due within 90 days. If you don’t meet the deadline, the IRS will consider the unpaid balance to be taxable income, and you can face the same tax issues already mentioned.
- Double taxation. Loans from your 401(k) can cause you to pay taxes twice because you’re repaying with after-tax money and then later, when you withdraw the funds in retirement, you’ll pay taxes on that same money again.
- Still be in debt. If you borrow from your retirement savings to pay off other debts, you’ve basically exchanged one debt for another—and taken on all the above disadvantages along for the ride.
Bottom-line: Tapping a 401(k) account is a tempting way to pay for that home, or whatever you seek on that day. Alternative approaches include a second mortgage, which is another source of needed funds, and mortgage insurance, which reduces the down payment required.
Basically, borrowing from your retirement plan for any reason will ultimately hurt you. It’s definitely a way to ruin your retirement savings and leave you at risk of having much less money than you had planned for to use in your Golden Years.