If you’re thinking of withdrawing or borrowing money from a 401(k) to pay for something you want to buy — or even to get out of debt — think again first. And then again and again, because there are some very good reasons not to raid your 401k account early. (Yes, even if you intend to put that money back or are planning to use it for something “good”.)
In a nutshell, retirement money should be for retirement — and nothing else. Doing anything else with that money is like shooting yourself in the foot and then expecting to win a race. Even if it weren’t, there are still 4 very good reasons not to raid your 401k.
1. It’s EXPENSIVE!
If you withdraw money from a 401k before you’re supposed to, you get tossed in the penalty box and slapped with a fine. Oh, and then taxed, too.
As the IRS web site states, “Distributions received before age 59 1/2 are subject to an early distribution penalty of 10% additional tax unless an exception applies.”
Put in English, that means that you’re going to have to pay federal, state, and local taxes on the money you take out, PLUS pay an additional 10% penalty. Not “just” a 10% penalty.
If your normal taxes add up to 35%, you’ll pay 45% of the money in taxes. So if you were to withdraw $5000 in that case, you’d wind up with $2750. Maybe you only need $2750, so that doesn’t seem like a bad deal, but would you pay 81% annual interest on a credit card? That’s essentially what you’d be doing: paying $2250 of your hard-earned money for the “privilege” of using $2750 of it.
2. No, it’s really, REALLY expensive!
Not only is it expensive to withdraw the money early now, but it costs you again later. Big time, because you’ll be missing out on the money you could have made from that money — money that you’ll need in retirement. A retirement account is your opportunity to become one of the rich who gets richer, so don’t squander that opportunity.
Want some numbers? Take that hypothetical $5000 early withdrawal; not only will you not get to keep the whole $5000 (see reason #1), but you won’t get the future earnings of that money either. If you had left the $5000 in there and never added another penny, in 30 years at 7% interest it would have grown to $38,061. It’s probably a lot easier to find the $2750 you need now than it is to find $38,061 later.
3. The math is crazytown.
Ok, so what about borrowing against a 401(k) instead of withdrawing money from it? You’re going to put the money back, so it’s not such a big deal, right? Wrong. If you believe that, you haven’t thought things through.
The money you originally put into your 401(k) is pre-tax money. That may sound like no big deal, but it is.
That’s because the money (and interest) you’ll have to pay back is money that you’re taxed on. So you have to earn a lot more of it in order to put the money back, because you have to pay taxes too. Then, when you eventually do take the money out when you retire, you’ll pay taxes on it again. This means it costs a lot more than it first appears to even borrow money from a 401(k).
It’s like borrowing a dollar from someone, getting to use 55 cents of it, and then having to make $2 in order to pay back the original $1, which you are then taxed on. That just doesn’t make sense. (And neither does borrowing from your 401k.)
4. Life doesn’t go as planned.
Still not convinced? Think back on the past year of your life. How many things in it went 100% perfectly as planned? I’m guessing none, or close to none. Sure, you probably had some great things happen, but were they 100% perfect and exactly the way you’d planned ahead of time? No. And that’s just how life is. Why would borrowing from your 401k go perfectly? It’s dangerous to assume that it will.
If you lose your job or quit before the loan period is up, the entire amount that you borrowed quickly comes due. If you can’t pay it back in the (very short!) time period allowed, it counts as an early distribution, and you’re back to dealing with numbers 1 & 2 — paying taxes & the penalty on it, at a time when you can probably least afford to do so.
Find the money you need somewhere else — like maybe by starting a side business or selling some stuff. It may not seem like it at first glance, but you’re a whole lot better off doing that than raiding the 401k. Plus, when you’re done, you’ll still have retirement money available. (In most cases, even if you have to declare bankruptcy.) So step away from the 401k account, and let it do its job.Posted in Retirement on 01.30.13 with 10 comments.