Taking money out of your 401(k) is an easy way to eliminate debt. But don’t do it until you’ve read what experts think.
Start with Evagrius Ponticus.
You’ve probably never heard of him, since he was a 4th Century monk. But he wrote the Eight Temptations of Man, which were later changed to the Seven Deadly Sins.
Ponticus noted the weakness in our souls and advised against giving into a variety of temptations. He probably wasn’t thinking about 401(k) plans, but the basic lesson is as applicable today as it was 1,700 years ago.
If you’re tempted to withdraw from your 401(k), or take an early distribution, it’s going to cost you a lot of money.
Let’s look at a scenario. Susie piles up credit card debt due a combination of poor money management and bad luck (reduced income from an illness). Her 401(k) has enough money saved to get her out of debt and fast. By withdrawing $15,000, she’ll be able to completely pay off her credit cards and start fresh. This sounds like a good idea, so goes ahead and contacts her account manager and requests the check. Susie has $25,000 saved, so she expects that her distribution, or early withdrawal, will leave her with a bout $10,000 in her retirement.
Unfortunately 401(k) withdrawals are taxed at your income tax rate plus an additional 10 percent penalty. Since Susie pays a middle class federal tax rate of 25 percent, she’ll have to pay 35 percent to the federal government for this withdrawal. That’s $5250. Her $15,000 loan is going to cost her $5250 to access. That means, after her withdrawal, her 401(k) will be reduced to $4250.
But that’s not all that Susie has lost. That $25,000 grows at an average annual rate of 8 percent, per year. Since she is 35, the money has 30 years to grow. If she never adds another dollar to her account, and continues to achieve 8 percent growth, she can expect to have a quarter of a million dollars in her account by the time she’s 65. Yes, that $25,000 will grow 10-fold in the next 30 years. If she withdraws $20,250 to pay off her credit card debts and is left with a balance of $4250 which grows at the same rate for 30 years, she’ll have nearly $48,000 in her account at retirement. So this 401(k) distribution or withdrawal will cost her the initial $5250 in taxes and an additional $200,000 in lost growth over time.
One of the reasons people like tapping into their 401(k) is because it is a quick fix that doesn’t require deep scrutiny of their finances and in many cases, doesn’t even require meeting with a loan officer or account manager. Also, retirement savings is our own money. We feel like we should be able to access and use our own money if and when we want to. Before you even think of canceling your 401(k), consider the alternatives to a premature distribution.
Almost 11% of workers with 401(k) plans took out a 401(k) loan in 2015, and the average amount was $9,500.
You can borrow up to 50% of your vested savings, up to $50,000. There are occasions when a 401(k) loan makes sense, such as paying off high-interest credit cards with a lower-interest loan. But almost every credit counselor since Ponticus’s days will tell you the cons outweigh the pros.
The beauty of a 401(k) is your contributions aren’t taxed until the money is withdrawn, and interest rates are relatively low. So the money you borrow isn’t taxed as long as you pay it back on time.
But you’ll use after-tax dollars to pay the interest, which is deposited back into the account. Then you’ll be taxed again on that money when you tap into your account after retirement.
The danger comes if you become unemployed or otherwise can’t repay the loan. You have 60 days to repay the loan if you lose your job. If you default, that loan becomes a distribution and you’ll pay taxes on the entire amount as well as a 10% penalty.
The whole point of a 401(k) is to defer taxes on your contributions and let the money grow tax-free. You can begin withdrawals without penalty at age 59 1/2. The theory is that you’ll be in a lower tax bracket in retirement, so you’ll be paying lower taxes on all that money you saved over the years.
The strategy only works if leave the money alone. It’s deposited in mutual funds and other investment options, so the rate of returns varies with the economy. But in general, 401(k) participants can expect a 5%-to-7% return.
In real terms, if an employee deposited $10,000 at age 30 and got a 6% return, it would turn into $17,908 in 10 years, $32,071 in 20 years and $57,435 by the time the employee turns 60 and is ready to head to Florida.
Even more drastic is the effect of cumulative deposits. Fidelity Investments manages 401(k) accounts for 13 million employees in 20,000 companies. It noted the stark difference between two 25-year-old employees, each earning $50,000 a year who defer 10% annually in a 401(k).
Employee A doesn’t touch his deferrals and at retirement has a nest egg of $537,000. That works out to $2,650 a month in retirement income.
Employee B takes out a loan that is repaid. But he stops contributing to his 401(k) for 10 years, then resumes deferring 10% of his income.
That gap will reduce his retirement fund to $396,000, or $1,960 a month. That’s $690 less than Employee A, which will pay for 16 ribeye dinners at Ruth’s Chris Steakhouse, not counting the tip.
At 16 cents per 3-ounce serving, it would also buy 4,058 helpings of Ramen beef noodles from Walmart. But who wants to work hard for 40 years just to slug down beef-flavored soup for dinner?
Another plus is that 401(k) funds are protected in bankruptcy proceedings. Nobody likes to the think they’ll end up there, but the fact people even consider tapping into their retirement funds often indicates they might need to overhaul their financial habits.
A Fidelity study showed that from 2007 to 2013, 24% of borrowers decreased their savings rate in the first year after a loan was taken, and 9% stopped saving altogether. Within five years, 40% of borrowers had reduced their savings rate from pre-loan levels, and 15% had stopped savings altogether.
That may not be a recipe for disaster, but it is a recipe for Ramen noodles. Before taking that step, it pays to investigate debt-relief alternatives. A non-profit credit counseling agency like InCharge can take a comprehensive look at your financial situation and offer free advice on how to eliminate your debt without raiding your retirement.
Many consumers enroll in debt management programs, where their bills are consolidated and they make one monthly payment to the credit counseling agency, which distributes the funds to creditors. With a debt management program, you’ll be able to achieve a lower monthly payment on your credit card debt, and lower interest rates. By leaving the money in your 401(k) alone and letting it grow, you’ll pay off your debt and see growth in your retirement plan.
It’s not as easy as simply loaning yourself money. You’d have to give up credit cards. That alone would make many consumers would feel as if they’d joined a monastery.
But take it from our old monk friend Evagrius Ponticus. Getting a 401(k) loan may not be one of the Seven Sins. But giving into that temptation can be deadly to your retirement.
(Grind, K.)(2015, June 15). Money Flows Out of 401(k) Plans as Baby Boomers Age. Retrieved from http://www.wsj.com/articles/net-outflows-befall-401-k-plans-1434408836
(NA)(2015, July 23). Five reasons to be cautious about 401(k) loans. Retrieved from https://www.fidelity.com/viewpoints/retirement/be-cautious-about-401k-loans
(Powell, R.)(2011, Oct. 6). That 401(k) loan may cost you more than you realize. Retrieved from http://www.marketwatch.com/story/that-401k-loan-may-cost-more-than-you-realize-2011-10-06