Before You Tap Into Retirement Savings.../ February 10th, 2016
If you're young, chances are you won't be retiring for a while—in face, retiring is not even on your mind.
So, here you are, struggling to balance your budget in your day-to-day life. What's the harm in borrowing from your retirement stash to get you through?
Cons outweigh benefits
A retirement account loan potentially jeopardizes your current financial state and could postpone the day you retire.
Even if your employer lets you make contributions to your retirement account while you have a loan, it will be difficult to maintain the same contribution level when you're also paying back the loan.
Borrowing from a retirement account is rarely advisable. Here are three reasons why:
Potential for lost contributions.
By withdrawing money from your account, you are reducing your principal. If your employer won't let you make contributions to retirement accounts while you have an outstanding loan, it stays low. Less principal means you earn less interest.
For example, if you normally contribute $4,800 a year to your 401(k), and your employer contributes 50 cents for every dollar, suspending your contributions would cause you to miss out on $2,400 in employer contributions in a single year. That's $12,000 over the five-year loan repayment period. This significant loss does not even include foregone investment earnings on the money over that period.
When you contribute to traditional retirement accounts, contribution money is withdrawn from your paycheck before taxes. If you take a loan from your retirement account, you'll have to pay back the loan with money that already has been taxed.
For example, if you borrow $10,000, you'll have to pay several thousand dollars of pretax income in addition to the $10,000 to get back to $10,000 after-tax income, depending on your salary and corresponding tax bracket.
Additionally, your retirement income will be taxed when you withdraw money in retirement, so you'll be hit twice.
Losing the value of compounding interest.
When you contribute to and leave money in your retirement account, it earns interest. When you borrow from your retirement account, you stop earning interest on the money you've borrowed because you've reduced the principal amount that earns interest.
If you take a few years to pay back the loan, that's several years of lost interest, which means it will take you longer to reach your financial retirement goals. You might have to work more years than you planned.
Borrow today and you could come short a few hundred thousand when you retire
To drive this home, say you are 30 years old, in the 25% tax bracket, and want $10,000 to pay for your tuition this year. To net $10,000 and pay the employer withdrawal fee and the IRS early withdrawal penalty plus taxes, you'll need to pull $15,485 from your retirement account. For the next six months you can't make any elective deferral contributions, and you'll miss your $2,700 employer's match.
That's $18,185 that won't earn compounding interest—for the next 35 years.
At a hypothetical 7% annual rate of return, you'll come short roughly $194,000 when you retire. The shortfall will be even more if you're younger at the time you make the withdrawal.
Borrowing from your future is a slippery slope
Even if you borrow money from your retirement and pay it back in a timely manner, you're heading for a slippery slope: it's easier to borrow from yourself a second time.
And, if you voluntarily or involuntarily leave your job, you're usually required to pay back loans within 30 to 90 days. It may be difficult to come up with the money on short notice—especially if you didn't choose to leave your job.
If you aren't able to pay back the loan in that time frame, the loan will be treated as regular taxable income and will result in an additional 10% early-withdrawal penalty as long as you're younger than 59 1/2.
Alternatives to borrowing from your retirement
Many high-priority expenses can take a big bite out of your budget, but there's almost always an option to borrowing from your retirement funds.
If you have a spending plan, review it and determine what you can cut. Reducing your spending instead of taking out a loan is always preferable. If you don't have a spending plan, create one—then track your spending closely so you adhere to it.
Still need help
There are times when you really do need an additional chunk of change. When you need to borrow money, the professionals at your credit union can help with the right kind of low-interest loan that will meet your immediate needs and won't damage your financial future or delay your retirement.