Top 10 list: Why you should never borrow from your 401(k)

Have you watched the balance in your 401(k) or other retirement plan grow to a substantial sum over the past several years? If so, that should give you a sense of pride and satisfaction—and the determination to keep contributing all you can so that it will stay on its upward trend.

However, for some people, seeing their accounts grow triggers a different reaction: temptation.

savings do not touch
Mike Kemp | Getty Images

They view their accounts as a source of quick and easy loans—perhaps to buy a house or a car, pay for a child's college education, start a business or even spring for something without lasting value, such as a vacation.

Often there's no lengthy application process or credit check, and you can probably get your cash in just a few days. Then you have five years to repay the loan (although you can do so faster if you wish, with no prepayment penalty).

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And you'll not only get a low interest rate, but the interest you pay goes right back into your retirement account, so it's like repaying yourself.

That's why so many Americans have taken this unwise path.

Neither borrower nor lender be

A study by HelloWallet reported that, of the $294 billion contributed to 401(k) plans by employers and employees in 2012–2013, about $70 billion—or 24 percent—was withdrawn for non-retirement purposes, including mortgage payments and credit card bills.

And a white paper from the Center for Retirement Research at Boston College estimates that about 1.5 percent of assets "leak" out of 401(k)s and individual retirement accounts each year on average—through early withdrawals, cash-outs or loans.

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The center estimates that aggregate 401(k) and IRA retirement wealth is at least 20 percent lower than it would have been without such leaks.

The common perception among borrowers is that they're only borrowing from themselves—so no harm done. But that assumption is seriously flawed.

"Pulling money from your 401(k) means that you're selling some of your investments. If they continue to rise in value, you won't get the profits and the compounding power that goes with them."

In fact, borrowing from your retirement plan is the best way to destroy your retirement-planning effort, putting you at risk of ending up in your 70s with no money. Here are the 10 best reasons I can think of as to why you must never, ever borrow from your account.

  1. Borrowing defeats the purpose of the account. The money's there for one reason only: to provide for your retirement. No matter how urgent you think your present situation is, it'll be nothing compared to what you'll experience when you're in your 70s or 80s without adequate funds. You simply must find another solution to today's problem.
  2. Loss of compounding. Pulling money from your 401(k) means that you're selling some of your investments. If they continue to rise in value, you won't get the profits and the compounding power that goes with them.
  3. You're likely to sell low and buy high. As you pay back the "loan," you're rebuying the previously sold shares—but at current (and probably higher) prices. You shouldn't need me to tell you that that's the exact opposite of what an investor should do.
  4. Added interest and fees. Most plans charge an origination fee of $75 regardless of loan size, and this goes to the administrator—not back into your account. Thus, if you borrow $1,000, you've lost 7.5 percent right away. While the interest you pay, which is based on prevailing rates (about 5 percent for many plans last year), goes back into your account, that's money you otherwise could have invested for potentially higher returns. So paying interest—even to yourself—reduces the amount of wealth you could otherwise generate.
  5. Suspended contributions. Many plans won't allow you to contribute to your 401(k) until you've paid off your loans. In some cases that could mean years, during which period you've lost the advantage of reducing your taxable income.
  6. Reduced take-home pay. Most plans require you to start repaying your loan via automatic paycheck deduction starting with your next pay. Thus, your take-home pay is reduced, possibly by more than the amount you were contributing to the plan before. And this repayment isn't tax-deferred, so your taxes could rise, lowering your net pay even further.
  7. Tax risk if you fail to repay by the deadline. Most 401(k) loans must be repaid within five years. If you fail in that, your employer will treat 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 future.
  8. Additional risk if you quit or lose your job. If you leave your employer, the loan will be due within 90 days. … But wait—you've already spent the money. If you don't meet the deadline, the Internal Revenue Service will consider the unpaid balance to be taxable income, and you'll face the same tax issues previously noted. And now you're in trouble with an unrelenting lender—the IRS.
  9. Double taxation. Loans from your 401(k) actually cause you to pay taxes twice. Why? 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.
  10. You're still in debt. If you borrow from retirement savings to pay off other debts, you've simply exchanged one debt for another—and taken on all the above disadvantages in the process. A study by T. Rowe Price found that borrowing $10,000 from a retirement plan will reduce your account balance at retirement by $100,000.

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A 2013 Fidelity study points to yet another danger: It found that, of 180,000 people who took out 401(k) loans over the past 12 years, 66 percent took out more than one loan, 25 percent borrowed three or four times, and 20 percent did so five times or more. Thus, initial borrowing could put you in danger of becoming a repeated borrower, thereby causing even greater damage to your retirement.

So for all these reasons and more, discipline yourself to avoid borrowing from your 401(k) or other workplace retirement plan, no matter how badly you need cash. Find another way to get it. Later, during your comfortable retirement, you'll come to appreciate what a huge favor you did for yourself by allowing your account to grow without setbacks.

—By Ric Edelman, chairman and CEO of Edelman Financial Services

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