Have you ever dipped into your 401k when you needed money? Maybe it was to pay off an emergency expense, a nagging debt, to buy a house, or some other reason that sounded good at the time.
If so, how’d that work out for you?
A 401k Withdrawal Has Consequences
Withdrawing money from your 401k account to meet an immediate want or need in your life can be disastrous to your future. Even if you do it for a responsible reason, it still has consequences that can damage you financially for the rest of your life.
2 Ways to Take Money Out of Your 401k
Let’s take a look at the two ways you can take money out of your 401k retirement account, and the consequences of each:
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401k Withdrawal: Taking money out of a retirement account means you’ll take a huge immediate hit financially. Not only will you have to pay your usual tax rate on the withdrawal, you’ll also have to pay a 10% penalty on top of that. This means you end up losing as much as 35-50% of the money you take out to taxes and penalties. You can get a more detailed explanation here.
- 401k Loan: You can also take money out as a loan. If you take out a loan from your 401k, you have to pay it back with interest. You don’t have to pay taxes or a penalties on the loan (that’s good), but there are several problems that you’ll need to think about before you do this.\401k Loans Have Their Drawbacks
There are 3 reasons why taking a loan from your 401k can spell disaster for your future:
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It Hurts Long Term Investment Growth: Even though you’re paying back the loan with interest, you’re more likely to get a better return in a more traditional investment such as a mutual fund. Plus, in a traditional investment, the interest is being paid to you by someone else and not coming out of your own pocket. This could cost you tens to hundreds of thousands of dollars of investment growth over your lifetime.
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You’ll Do It More Than Once: People who take loans from their 401k tend to do it more than once. It can become a habit, thus compounding the problem of diminished returns I mentioned above.
- You Contribute Less: When you’re in the middle of paying off a 401k loan, you will have a tendency to make fewer contributions to your 401k, if you make any at all. Again, this hurts the long term growth prospects of your account and will cost you a ton of money over the long term.
Borrowing From Your Future
Overall, borrowing or withdrawing money from your 401k account can be very detrimental to your present, and especially your future. I’ve always told people that borrowing from any source will always make you poorer. But when you borrow or withdraw from your 401k or other retirement account, it sets you up for a double whammy of lost investment growth that in my opinion is just not worth it.
My Recommendation
If you must borrow money, don’t sabotage your 401k to do it. Even better, learn to set yourself up for never having to borrow again by putting together a solid plan for getting out of debt and do what it takes to make that happen.
When you take complete control over your finances instead of letting your finances control you, then you start winning financially.
Your future will thank you!
Question: Have you ever taken money out of your 401k to take care of an immediate need? Leave a comment and tell me your experience.
Article originally published on Celebrating Financial Freedom. Used with permission.
Dr. Jason Cabler is a Christian personal finance blogger, author, and speaker. He teaches how to get out of debt and live a debt free lifestyle through his Celebrating Financial Freedom blog and self study course. His book How to Budget: The Quick and Easy Guide to Making a Budget That Works is now available (more info here). He can be reached for interviews or speaking engagements by email, and can be found on Twitter, Facebook, and Google +.
Publication date: April 16, 2014