We all know these common-sense investing rules: Buy low and sell high. Diversify your investments. Spend less than you earn. Learn from your mistakes. Another is never borrow money from your 401k. After all, your 401k probably makes up the bulk of your retirement nest egg, but what if you need to pay your bills?
Should you borrow money from your 401k to cover past due bills?
Nearly 20 percent of 401(k) plan participants who are allowed to take out loans against their 401(k) savings do so, according to the Employee Benefit Research Institute. And when they borrow, they take out about 16 percent of their assets. You won’t find many financial advisers who will recommend that action so clients borrow from their 401(k) plans to build a swimming pool or buy a new car. But some say it might make sense to use some of it to repay a high-interest loan if there are no other ways to do it. Here are some reasons why you should, and shouldn’t, use your 401(k) plan as a piggy bank.
Why you shouldn’t borrow money from your 401(k)
- Because you’re no longer saving. If you borrow money from your 401(k) plan, you probably won’t be allowed to make additional contributions until you’ve repaid the loan. Even if your plan allows you to make additional contributions, it’s easier said than done when you’re trying to repay the loan.
- Because you’re losing money. If you not are not making additional contributions, you are missing out on potential growth from investments. Not only that, but you’re paying yourself back with after-tax money, and that’s defeating the purpose of the 401(k).
- Because time is not on your side. Most 401(k) calculations figure that your money will double over eight years on average. If you borrow from your plan to, say, put a down payment on a house, you’ll lose out on an opportunity to double your money within those eight years. Chances are, you’ll never reach the total that it would have reached if you didn’t take the loan.
- Because you’re stuck. Most plans won’t let you quit your job if you have an outstanding 401(k) loan balance. So you may have to turn down a great job — with a higher salary — unless you can repay the loan immediately or are willing to pay the taxes and the penalty, which, of course, further hinders your growth opportunities.
- Because you may be living beyond your means. Borrowing from a 401(k) often means you are living beyond your means. If you are, you need to re-examine your budget and your spending habits. It may mean that you are financially out of control, and you may need help.
Why you might want to borrow money from your 401(k)
- Because you have no other choice. You have an urgent need for the money, and you don’t have a rainy-day fund or any other pot of money to use. You can’t borrow from a friend or family member, and you can’t get a bank loan or a home equity line of credit.
- Because you need money for an excellent investment opportunity.What constitutes an excellent opportunity? Buying a house for much less than market value. Paying tuition, which will lead to a degree and a much better paying job. Investing in a business or in a financial product that has excellent potential.
- Because it’s the cheapest loan available. If you have credit card debt with a very high interest rate, you can borrow relatively cheaply from your 401(k) plan. The interest rate from your 401(k) plan may save you money in the long run. Or maybe you must borrow money, but your credit score is low, and money from your 401(k) is much cheaper.
- Because you have very secure employment. If you borrow from your 401(k), it helps if you have a stable job and you are well liked by your employer. You can’t take the chance that you might be laid off or fired while you still owe money because you will have to repay the 401(k) loan immediately or pay taxes and a 10-percent penalty on the loan.
- Because you’re repaying yourself with interest. If you borrow money from your 401(k), you repay the loan with interest. That beats paying interest to a bank or some other lender.
As you can see, there is a lot to think about when deciding whether to borrow from your 401(k). Don’t do it unless you absolutely must borrow money and you have no other choice. Consider the consequences and determine whether they are manageable.