Don't Tap Your 401k to Pay Off Debt

If you take money out of your 401k to pay off your debts, you may regret it later. Taking out a loan or an early withdrawal will reduce your eventual retirement account and may force you to work longer.

By taking money out of your 401k account, you reduce the benefits of tax-free compounding that are key to building up a substantial balance. Experts recommend trying other alternatives first, including lifestyle changes to reduce your spending.

This is especially true if your employer matches your contributions. In order to get the maximum benefit from your 401k, you should always contribute enough to get the maximum employer match.

If you face a real emergency, and have no other safety net, it's acceptable to tap into your 401k plan, financial planners say. But if your problem is that you are living beyond your means and need to pay back your creditors, watch out. You could be paying your way right out of a secure retirement.

Just over half of all 401k plans make loans available to employees, according to the Employee Benefit Research Institute (EBRI). This is seen as an incentive to get employees to participate in the plans, because they are more likely to sock money away if they know they will be able to access it in an emergency.

But you should really think of your 401k as off-limits until retirement. Don't use it as a safety net. You can set up other vehicles for forced savings that will enable you to get at your money without penalties. For example, you can have your bank automatically take money from your checking account each month and deposit it in a money market account.

According to the EBRI, individuals between 30 and 59 years old are the most likely to take out 401k loans.

For younger people, retirement may seem a long way off, but remember that when you retire you want to live off your savings. You don't want to start working again at age 75! Since the amount you'll receive from Social Security probably won't be enough to sustain your lifestyle, your 401k balance is vital to your retirement happiness.

Taking out a loan can have a big effect...
Taking out a loan on your 401k can have a drastic effect on your eventual balance at retirement if you stop contributing to the account while you are paying back the loan.

Here is a hypothetical example of what a loan can do to your retirement savings. Say a participant (George) is 35 years old, earns $40,000 a year, and has a 401k balance of $20,000. He contributes $2,400 a year (6% of his salary), and his employer match is $1,200 (3%). Assume he gets an annual return of 8% on his account. If he continues saving at this rate until age 65, his nest egg will be about $583,723. (This is assuming all factors remain constant.)

But George wants a new car. He could afford a compact, but he decides that an extra $10,000 will let him get the Sport Utility Vehicle he wants. He takes out a $10,000 loan on his 401k and pays it back over five years, at an interest rate of 5%. He can't afford to continue making his contributions while he is paying back the loan, though. When he reaches age 65 his account will be worth $458,673.

That difference of roughly $127,000 in principal translates into a loss of $7,620 a year in retirement income, assuming a rate of return of 6%. That's about $630 a month - quite a chunk of cash.

Consider this. Elizabeth Allen, a Certified Financial Planner in Michigan, has a client who at 71 years old was forced to get a part-time job to make up only a $100 shortfall in her monthly income. "There was nothing we could cut from her budget. The only way for her to live was to earn that $100."

In George's case, he could have minimized the negative effects if he had continued contributing to his 401k in addition to paying back the loan. In that case, he would have ended up with $578,275 in principal, or a shortfall of just $5,000.

So, if you absolutely have to borrow from your 401k plan, make sure you pay the loan back as quickly as possible, and continue to make contributions to the plan in addition to the loan payments.

Another point that is often overlooked is that you will be taxed twice on the loan amount. The money you borrow is money that you contributed before taxes. But you pay it back with after-tax money (unlike your contributions, it is not deducted from your paycheck before taxes). When you withdraw the money at retirement it will be taxed again.

...But taking an early distribution could be even worse! Say George decided simply to withdraw the $10,000. (He could do this if he were changing jobs, for example. But remember, if you are still working for the same employer you can only take an early distribution in a hardship case.)

The problem is, he would have to pay about 50% in taxes and penalties, so he would actually have to withdraw $20,000 in order to get $10,000 cash. That means starting over with the 401k, and a further reduction in the balance at retirement.

How's Your Spending Behavior?
Calculators available on the Internet that seem to give a simple answer about whether you should take a loan on your 401k don't necessarily tell the whole story because they cannot take into account one huge variable -- your spending habits.

Here's a story related by Ms. Allen about one of her clients. The 50-year-old woman cashed out her entire $125,000 account to pay off her credit card debt and that of her two daughters, as well as to put a down payment on a home. She only saw about $62,000 of the money however - the rest went to the IRS and the state of Michigan.

Now, says Ms. Allen, a year later, this person has run up more credit card debt - only this time she doesn't have her 401k to bail her out. She has taken on a second job. "She'll be working for the rest of her life, and that's sad."

This case, while extreme, illustrates the problem with using money earmarked for retirement to take care of immediate needs. Once it's gone, it's gone. Also, many people overlook the fact that 401k money is the only money you have that is protected from your creditors. They can't touch it, even if you declare bankruptcy.

Before you mortgage your retirement (and possibly commit yourself to a life sentence of work) you should look at every other possibility for reducing debt - a home equity loan, debt consolidation, even taking out a second mortgage on your home, experts say.

Even if you end up losing your home, it won't be as bad as ending up without retirement income, says Russell Hall, a CFP in Wichita, Kansas. "You can probably get another home. The worst thing is to lose your retirement future."

This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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