3 Reasons to Not Borrow from a Retirement Account

Dear Mary: I am thinking of taking a loan from my 40l(k) retirement account to pay off my credit-card debt. I can repay the loan with payments taken directly from each of my paychecks, without any penalties. The interest rate is not too bad, and a lot less than I am paying to my credit card companies now. This seems like a great idea to me, but I’m worried I might be missing something. Sharon

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Dear Sharon: I would not recommend you take a loan from your retirement account to repay your credit-card debt for these three reasons: 

1. Uncertainty. If you leave your job for any reason before the loan is repaid, the entire balance becomes due and payable. That’s the law. You’ll have a couple of weeks to come up with that money. If you cannot, the balance owing will be converted to a withdrawal. You will be hit with early-withdrawal penalties and you will owe both federal and state taxes on the entire remaining balance. The penalties are stiff because you’re not supposed to have access to this money until you are at least age 59 1/2. The penalties and taxes could easily add up to half of the amount you owe. Ouch! 

2. Stunted growth. You lose the benefit of growth while those funds are being loaned out to you. The reason you are contributing at all is to allow money to grow steadily over a long period of time to support you during your non-earning years ahead. Taking money out brings that process to a screeching halt. 

3. Double taxation. The benefit of a traditional 40l(k) account is that you get to contribute and invest pre-tax dollars. You get to defer taxes until you take it out in retirement. If you borrow now, you must repay the loan with after-tax dollars. Are you with me? If you borrow say, $10,000 you will have to earn about $13,000 gross to end up with $10,000 after-tax dollars to repay the loan. You don’t get to repay with pre-tax dollars, so that’s the first taxation. Then, when you retire, you will pay tax on the same $10,000 dollars—taxation number two. All money in traditional retirement accounts is taxed upon withdrawal regardless if the funds were borrowed then paid back with after-tax dollars. 

It is just too risky and expensive to borrow from a 401(k). If you are really strapped, you could halt contributions to your account temporarily, while leaving the balance alone to grow. That would beef up your paycheck with more money to pay down your debt.

Stop thinking of your 40l(k) account as your personal ATM machine. That money is simply out of reach for now.

My advice is to get busy repaying your credit card debt from your current income. If you stop adding new purchases to those accounts and take advantage of my Rapid Debt-Repayment Plan, you will be out of debt in record time—with your 40l(k) account intact, and steadily growing.

Dear Mary: What if I put my money in a CD (certificate of deposit) for say one year, but have an emergency and need the money before that? Can I get my hands on it? Edie

Dear Edie: Yes. It would be considered an early withdrawal and for that you would be penalized pretty heavily. Depending on how far you are from the maturity date, they will reduce the guaranteed interest you would have received. The penalty applies only to the interest, however, never to your principal or initial deposited amount.

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6 replies
  1. Donna
    Donna says:

    Mary, I would agree with you for Sharon’s situation.. but I do have a question which has bothered me and my husband for quite sometime. We both contributed to our pre-tax fund through our employment. Upon retirement we had our financial advisor handle our 401k were to be invested. I will say that both my husband and I currently have a decent pension to live on but we lost over 30,000.00 just shortly after retiring in our 401k and since that was just under half of our hard earned money I still feel we could have withdrew it and came out ahead even after the penalties..remember know one knows the future..after all our years of doing the “right thing”.. What do you think??

    Reply
    • Guest
      Guest says:

      Donna … financial advisors do not work for free. From what you say, you hired a professional to work for you and you likely chose one that is “commission based.” That means that advisors charges you a percentage to invest the money. That was you choice. You could have rolled your 401k funds into traditional IRAs, then paid taxes only as your withdrew the money in retirement. Had you withdrawn the money earlier, what would you have done with it? You would have lost up to 50% in penalties and taxes to be paid at the time. Then what? Invest it? Where, how? You would have likely sought the services of a professional then, as well.

      Here is a little known fact of 401(k) type retirement accounts. The fees to manage them are horrendous. That is not openly revealed because the fees are quite hidden. I’ll write on this in the future, so stay tuned.

      Reply
  2. Kace
    Kace says:

    I like your advice to Sharon. I might add one thing that I don’t often see mentioned when discussing early withdrawal penalties. My spouse and I did an early withdrawal for a down payment on a house. We were expecting the 10% federal penalty, but our state penalized us, too!

    Reply
    • Guest
      Guest says:

      Kace … there is a 10% penalty you paid up front upon withdrawal. Your 401(k) administrator is required by law to withhold this amount. It is a penalty. THEN you must pay taxes on the entire amount. That is federal income tax and also state income tax, if you live in a state that has that tax. Your state did not penalize you. They simply saw your withdrawal as ordinary income. It was money you did not report as income when it went into your 401(k) account on the front end. All that to say, yes it is shocking to withdraw what you believe is your hard earned money only to have up to 50% of disappear you can get your hands on it.

      We’ve come to believe that 401(k) and other similar qualified retirement accounts are 100% fabulous. They aren’t. There are negatives. For example … the fees. All along the way there are middlemen involved–administrators. It is now estimated that fees can be at high as 30% and that is not counting early withdrawal penalties or taxes. That means you’d better hope and pray for fantastic growth to end up with more than you contribute on the front end.

      Reply
  3. Guest
    Guest says:

    Your advice to Sharon is sound. It’s important to realize that even if she were to lose her employment involuntarily, that layoff would trigger the obligation to immediately pay back the full amount of the loan she had taken against her 401K, and if she couldn’t do that, she’d still be hit with that early withdrawal penalties and added taxes at a time when she would already be under the financial stress the accompanies the loss of a regular paycheck. Choosing to suspend her contributions to the 401K in order to make larger payments on her credit card debt is a much better option, but just remember that, depending on her income tax bracket, the amount withheld from her paycheck for federal and state income taxes may go up a bit when her pre-tax contribution to the 401K goes down. The good news is she can keep on adjusting the amount of her contribution until she finds the balance that works for her.

    Reply

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