Many organizations allow their employees to borrow money from their retirement plans. While this is very tempting for some people, it is not always the best option. In fact, in most cases taking a loan against your retirement is inadvisable.
You’re stealing from your future self
It is never a good idea to take unsecured debt (credit cards & unsecured loans) and pay them off with retirement money. Your borrowed money will not be invested for the entire time the money is outstanding from your retirement plan. Therefore, you forgo any potential investment gains from all borrowed funds for the duration of your loan. But perhaps most impactful, you lose out on gains from compound interest. So remember, when you borrow from your retirement plan, you are borrowing from your future self. Even when you pay back the principal and interest, you likely won’t break even in terms of lost investment growth by the time you retire.
You’ll have less options
Borrowing from your retirement not only decreases your retirement, it also reduces your options with the unsecured debts in the future. For example, what if you have a major loss of income or large medical expense and and realize that bankruptcy is the fresh start you need? If you have tied your unsecured debts to your retirement, you will not be able to file on those (if you’re able). For more info on bankruptcy (which should be a last resort option), read Bankruptcy: the good, the bad, and the ugly.
It’s not free money
While borrowing against your retirement means no credit check required, it doesn’t mean you won’t pay interest! They may also charge you an origination or set up fee. There is also the aspect of pre-tax vs post-tax to take into consideration. Unlike the initial retirement contributions which were likely tax deductible, when you pay back your loan, you do so with post-tax dollars. Consequently, a $100 loan repayment reduces your take-home pay by $100. Worse, when you take the money out of your retirement plan during retirement, you will pay tax on the same money again.
There are risks
There is a huge risk with retirement loans that many people do not know, which the risk of job termination. The reason that termination poses such a risk is that the terms of retirement loans are generally tied to your employment status with that employer. If you cease working with your current employer, the entire remaining balance of the loan is usually due within 60 days. If you are unable to pay back the loan balance during that quick time frame, the entire amount you are unable to pay is deemed a distribution. This is likely to be subject to significant federal and state income tax and early distribution penalties.
Financial Counseling can help
Avoid all this hassle and stress! Talk to one of our highly qualified and certified financial counselors to see if a Debt Management Plan would be right for you. By making your payments on a Debt Management Plan through LSS the creditors may decrease the interest rates and, in some cases, decrease the monthly payment. For your free and confidential financial counseling session, call us at 888.577.2227 or GET STARTED ONLINE at any time.
For more info check out How to avoid the biggest 401k blunders.
Author Katie Eastman is a Certified Financial Counselor with LSS. She specializes in budget, credit, and debt counseling.