Your 401(k) is Not a Savings Account

As a retirement plan specialist a large part of my daily job is helping participants with their retirement plans. One of the most common reasons participants meet with me is because they need money and they are looking to take it out of their retirement plan. Unfortunately this conversation almost never goes over too well since they are usually upset with the fact that they cannot cash out their entire account, do a 401k rollover, or take out a 401k loan from the company match money that hasn’t vested and I get more than an earful.

What is probably more shocking is that many of the people coming in looking to take money out of their retirement plan only need a small amount (generally under $1,000) to cover some unexpected expenses and I’ve seen people take out $500 loans on three year terms. With the majority of people tapping into their employer plans for emergencies I think this highlights the importance for keeping a cash emergency fund available even if it isn’t significant.

First, Congratulations

I have to applaud those who actually take the time to enroll and begin contributing to their plan, especially if money is tight. Generally, the people who need to be borrowing against 401k are earning modest incomes and are just able to make ends meet. There is a lot to be said for someone in such a situation. They understand the importance of saving and have learned to make due without that little extra money coming home in their paycheck.

Taking the Next Step

While participating in the plan is a great initial step it is often the only savings many people are taking part in. It is automatically taken out through payroll so it is simple. The problem is that people stop there and don’t apply the same technique for other savings. If you can spare $10 every two weeks from your paycheck you should strive to save at least $5 or $10 as well for your emergency savings so you don’t have to treat your retirement plan as an emergency fund.

The problem is that this takes additional work and you either need to change your direct deposit to put money into a savings account or you need to manually set up the transfer or deposit. The other big problem is how easy the money can be to access. Most people simply set up their savings account where they do the rest of their banking and more often than not the savings account is linked to the checking or even their ATM card. The ease in accessing this money can make it difficult for some people to keep the money in savings where it belongs and occasionally tap into it. The benefit of a retirement plan is that the money isn’t as easy to access so after a few years of constant contributions and no withdrawals people are surprised at how much they have saved and see that as money that can be used for other things.

Loans Should Be Your Last Resort

If your plan allows you to take a 401k loan it should be treated as a last resort. Some people argue that tapping into your 401(k) isn’t all that bad of an idea because it is your money and you are simply paying yourself back the interest. While that is true you are still hurting yourself over the long run. Money that you take out of your plan can no longer earn interest or see capital gains. For some loans this could be a period of five years of foregone compounding. Second, most people who take a loan end up stopping their contributions so that they can make the loan payments. This just compounds the problem of foregone gains and what is even worse are those who end up forgetting to begin contributing again once the loan has been repaid.

Another thing to consider are the tax consequences on the loan. Money you borrow from your plan is pre-tax money, but your loan payments are from after-tax dollars, and then once you retire and begin to pull money out those dollars are also taxed. This means you are effectively going to be taxed twice on the money that you borrowed. If that isn’t a raw deal I don’t know what is. Finally, in the event you default on your loan because you change jobs and stop making loan payments or simply stop making loan payments altogether the IRS will treat that as a premature withdrawal resulting in taxes owed on the distribution with a 10% penalty on top if you were under the age of 59 and a half.

Check to See if Your Employer Offers an After-Tax Retirement Account

If you find it difficult to save money the traditional way and want to avoid the pitfalls of tapping into your qualified retirement account there may be another option available to you in the form of an after-tax portion of your 401(k) or 403(b). Some employers actually offer the option to also contribute after-tax dollars into your retirement account, either within your current plan or through a separate account.

The benefits of doing this are that you can begin saving money easily through payroll deduction just like your current retirement plan and yet you have access to 100% of this money without needing to take a loan or worry about IRS early withdrawal penalties. While you won’t receive the tax benefits of a qualified plan you can at least create a cushion of money that is available without excess penalties or taxes. Most plans allow this money to go into a savings type account or at least a fixed rate fund but many also allow you to invest the after-tax dollars in the same types of funds as your primary retirement plan.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

6 comments
Natalie Davenport
Natalie Davenport

Thanks this is very helpful stuff. I'm still doing some more research on 401k though. My dad is recently retired and it would be helpful to him if I get some more info.

vause
vause

You forgot one important fact. If you were to be fired or quit your job you will have to repay the loan back in full usually within 90 days. If you do not repay it back that it is considered a distribution.

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Jeremy
Jeremy

Dennis,

Typically the most you can afford to put away should be saved into your 401k but it does depend on a few things.

For example, it depends on if there is a company match or not and how much they match. Generally speaking you should contribute enough to get whatever match you can since that is the best immediate return (vesting schedules aside).

But once you get the full match there may be a situation where adding more to a 401k may or may not be the best course of action. For example if you have to put away 5% of your pay in order to get all of the match and that comes out to around $2,200 a year yet you have determined that you can reasonably save 10% of your income where do you put that?

Since to get to 10% you'd need to contribute another $2,200 per year and this falls under the IRA contribution limits it may make sense to put the remainder of the money into say a Roth.

The problem is now though that you are saving 10% of your income yet only getting a pre-tax deduction of 5% so up front the savings isn't quite as good, but half of that savings will also be tax-free down the road.

The other thing to consider is the very generous contribution limits in employer plans at $15,500. If you can save more than $4,000 a year and would like to reduce your current tax bill as much as possible it would make sense to put as much into the 401k.

So, it is a tough question to answer since it depends on many factors, but ultimately you should:

1. Contribute enough to get any sort of company match
2. If there is no match and current taxes aren't as much of a concern and your total amount you can save is less than $4,000 consider a roth instead.
3. If you need to save more than $4,000 a year or taxes are a concern consider sticking to the employer plan.

For me though I like to do both because diversifying your tax liabilities is a smart thing to do considering we have no idea what taxes will be like once retirement comes. So I contribute enough to get all of my company match, plus a little extra to get some additional tax benefits and then I try to fund a roth IRA as much as I can throughout the year as well.

Dennis
Dennis

What percent of your income should be you placing in your 401k?

Jeremy
Jeremy

Danny, thanks for the kind words and that's a nice site you have there.

Danny at Money Socket
Danny at Money Socket

Hey Jeremy,

First of all, great site you have excellent content such as this post. Many people think the 401k is the end all, cure all and have no other savings. Borrowing against it is detrimental in my opinion aside from the opportunity cost (lost compounding). It effects them mentally too, if they keep borrowing against their 401k they'll get into a nasty habit and could put their future in jeopardy. Also, they'll never learn so they STILL won't have an outside savings. Keep up the good work Jeremy, I'll be a regular reader. Check out my site if you get a chance.