The Cost of Dipping Into a Retirement Account

More people are taking loans from their retirement accounts—(401(k), 403(b) or what have you—than ever, simply because they can. Here’s the problem: Seeing one’s retirement account as a savings account or worse, a personal ATM machine. That’s so ridiculous I cannot even tell you. Sure it’s your money, but it’s not your money now. It’s for later. It is out of your reach, so you need to get it out of your mind.

Borrowing from the nest egg, from retirement savings

 

Pre-tax dollars

The beauty of an IRS-approved retirement account is that you get to save pre-tax dollars. It’s no secret that what you see in your paycheck is not the full amount you earned.

In fact, the amount in your paycheck is shrinking and many of our elected officials are trying to shrink that even farther by increasing taxes. You know what I mean if you live in California one of the most heavily taxed state with a governor who is threatening to once again increase sales tax, personal income tax, and taxes on small businesses. Did I mention my husband and I left California for this very reason? But I digress ….

A retirement account allows you to save your money before it gets taxed. If you take your money home, you have to earn about $1.00 to see $.75 in your paycheck. But if you put it that dollar into a retirement account instead, you get to deposit the entire $1.00. You get to invest the $.25 that belongs to the government. It’s not a gift; you will have to pay that $.25 to the government eventually. But for now you get to keep all the growth you will achieve by investing the government’s money! Get it? And it’s all locked up so it is safe from YOU. That’s the beauty of a retirement account.

Hands off

Now, if you go and stick your hands in there and borrow some of that money you really mess things up. There are rules, conditions and penalties for doing that. But the biggest penalty of all is that you stop the machine that makes those dollars grow. Sure, it can be slow growth at times, but it’s growth nonetheless.

There are lots of reasons not to borrow from a retirement account, but I think the biggest is the rule that should you leave your job for ANY reason, that loan becomes all due and payable. You’ll have a couple of weeks to come up with the money. And if you can’t? That loan will be automatically converted to a cash withdrawal. Between the penalties and taxes you will owe on it right away, it could cost you up to 50%. Gone. Vanished into thin air. That is just too risky.

Trouble with borrowing

Here’s an example: You borrowed $15,000 from your 401(k) for your daughter’s wedding. You felt OK about that since you immediately started a repayment plan that includes interest to yourself.

A couple of months later you got a pink slip—a shocking, unexpected layoff. You get a notice that you have 14 days to come up with the entire amount owing, which is $14,650. You can’t do it!

The plan’s administrator immediately converts that $14,650 to a “cash withdrawal.” BAM! Just like that you owe 10% penalty on the entire $15,000. Then the entire $15,000 is immediately reported to the IRS as ordinary income upon which you owe federal and state (if any) income tax. Your federal tax rate is 28% and since you live in California you must also pay 10% to the state. Do the math: 14,800 x (10% + 28% + 10% = 48%) = $7,200. That’s what you owe in taxes. Can’t pay? Then you’ll have to agree to a payment plan with the feds and the state tax board—plus interest, of course. Kaching!

Whatever will you do? You don’t have a job, you can’t afford the bills you have already. How will you take on two more monthly payments to creditors who are anything but understanding, kind and forgiving should fall behind?

Just don’t do it

Thankfully, this was only an example. Whew! You still have time to reconsider taking a loan from your retirement account. Here’s my suggestion: Don’t! Do not even think about it. The money in your retirement account will become your safety net in the future. Live as if the money is not even there. Just save it then forget it.

It’s time to step into the confessional booth. Have you borrowed from  a retirement account? Did you pay it back? Or are you thinking about borrowing? Tell us about it in the comments below. Confession is good for the soul!

Updated 6-21-19


You should always seek counsel from an attorney, tax or other qualified professional for specific details relevant to your situation and before taking this advice or making any financial decision with regard to retirement accounts.

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7 replies
  1. Momhat
    Momhat says:

    You are ignoring the use of an IRA after age 59-1/2, as well as the difference with a Roth IRA. There are very specific differences in both situations.

    Reply
  2. Luisa
    Luisa says:

    I withdrew a lot of money from my IRA to pay off debts incurred by my husband. Though I had not known about them until we were divorcing, I was legally responsible. I used the IRA money, paid a lot in taxes as a result, and was not able to replace it. It was twenty years ago and I was desperate and scared, but it was a huge loss. I did not understand the consequences before going into it.

    Reply
  3. Loraine
    Loraine says:

    What about paying off a large medical bill. It is my understanding you can use the money without any penalities, is this correct?

    Reply
    • Bonnie Haruch
      Bonnie Haruch says:

      IRA withdrawal, not from 401k and only on medical expense OVER 10% of Adjusred Gross Income (the number at the bottom of page 1 of your tax return )

      Reply
  4. katybee
    katybee says:

    Been there done that. Borrowed 15k for closing costs on a home purchase in ’04. Lost the house to a divorce/housing bubble in 2010. Still have 3yrs to finish paying off that mistake. NEVER AGAIN!!!

    Reply
  5. Sophie LaFontaine
    Sophie LaFontaine says:

    I’ve borrowed twice from my retirement account. Both times I paid it off in two years. I used the money to buy a rental house each time. I feel that the benefit of the far-lower interest rate outweighed all the cons. The money went into investments (rental homes). I’m preparing to borrow a third time, to buy a third rental house.

    Reply
  6. Bonnie Haruch
    Bonnie Haruch says:

    Only the remaining balance of the loan is taxable, not the beginning balance. And if you’re thinking about a withdrawal from your 401K, ( not good either ) first roll it into an IRA because there are more exceptions to the penalty. It’s still taxable.

    Reply

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