Avoid 401(k) Loans

Ray’s Take Many employers offer 401(k) plans that grant participants the option to take out a loan. And when times are tough – or maybe you really, really want to renovate your kitchen – it’s tempting to withdraw money from your 401(k) for a loan.

The loan gets paid back over time by payroll deductions. After all, you’re borrowing money from yourself – what could go wrong? It looks easy and painless on the surface. But digging deeper, there are some very good reasons not to do it.

If you leave your job, the full balance left on the loan becomes due immediately. And the same rule may apply if you are downsized from your job. Defaulting on a 401(k) loan makes the outstanding loan balance into a withdrawal subject to full income tax and, if the borrower is not 59 1/2, the 10 percent penalty too.

The debt typically has to be repaid within five years, or tax and penalty apply to the balance. These sound like some pretty good reasons not to take a loan from your 401(k), but there’s an even bigger one.

The biggest drawback to these loans is opportunity cost that comes with the missed potential growth of your investments. In addition to the lower balance in the account making less money, people typically reduce or stop contributions to their 401(k) while repaying a loan, which means they’re missing out not only on their normal contribution but also on their employer match.

People are living longer than ever, with fewer safety nets. That makes taking loans from your 401(k) even less of a good idea than ever. When you borrow from your 401(k), you are borrowing from your future self and even when you pay back the principal and interest, you probably still won’t break even in terms of lost investment growth by the time you retire.

Dana’s Take Seeing money in your 401(k) account is like smelling freshly baked brownies – it’s hard to keep your hands off. Those of us who are more impulsive may have a hard time leaving that big pile of money alone.

Having a financial planner on retainer to manage your investments can be like having your mother in the kitchen when those delicious brownies emerge from the oven. While a financial planner cannot stop you from raiding your savings, he or she can go over the benefits of leaving that money to grow and compound for decades.

As Ray’s father, Denby Brandon Jr., used to say, “It’s very inconvenient to be old and broke.”

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