Common Reasons People Take Out a 401k Loan
Know the Costs And Risks of Dipping Into Your 401k Before Retirement
If you had to quickly answer the question, "What’s your largest asset?", what would you answer? After their house, most people would say it’s their car. But for many of us — especially if we’re in our 40s or 50s — our 401k retirement account is likely worth more than our car.
So, why are we so often reckless with our 401k in ways we would never be with an automobile? In other words, why do we borrow from our 401k? Here, we identify the most common (and potentially risky) reasons people take money out of their 401ks.
A House Down Payment
This one seems to make sense on the surface as you are moving money from one investment to another — assuming home values rise while you own your home. But this really means you have two mortgages — one on the house, and another on your retirement. Worst-case scenario, you might have to sell the house to fund your retirement.
A Child’s Wedding or Lifestyle Upgrades
This is symptomatic of the live-for-today attitude towards money that is common in today's society. It makes zero sense to spend $20,000 of your retirement nest egg on a one-day event, new car or home remodel. You might make some great memories or enjoy your new cabinets, but the consequences will be considerable and lasting.
You can borrow money to pay for college, but you can’t get a loan to fund your retirement. Work with your budding scholar to figure out some other way to pay for college. Yes, a college education is a great gift to your children — but so is retiring with enough money so that your kids never have to support you. If you must pay for their college, there are better ways to balance paying for your child's education and saving for retirement.
Consequences of Dipping Into Your 401k
Before you dip into your 401k, understand the real cost and risk of doing so. Withdrawing a significant chunk of cash from your account sets you back three ways. First, obviously, your nest egg is reduced. Second, you are missing out on all the compound interest those savings would be earning. That could be a substantial amount of money if you borrow a hefty sum for a couple of years. Third, some 401k plans don’t allow you to contribute until you repay any outstanding loans. This effectively puts your tax-deferred retirement savings strategy on hold.
Finally, if you lose your job while you have an outstanding loan, you will have to repay the entire loan in very short order or face significant taxes and penalties.
Bottom line: Avoid 401k loans except in the case of true and dire emergency. View your automatic contribution to the fund as money that’s gone forever. (It will make for a nice surprise when you retire!) Establish an emergency fund of six-month living expenses to handle unexpected situations. Save up for significant purchases like houses, cars, and weddings. In short, never let today’s desires place tomorrow’s security at risk.