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.
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.