You’ve probably heard the phrase “change is the only constant.”
Just like we can always count on “death and taxes,” we can also always count on the fact that life changes. This means the economy changes, laws change, and the way we plan for retirement changes too.
Strategies that worked in the past, may not work as well going forward.
In 1978 a section of the Internal Revenue Code was enacted that made 401(k) plans possible. With this new legal change, new strategies could be used to plan for retirement.
Also, it changed the way people plan for retirement. It put more of the responsibility of saving for retirement on the shoulders of the individual. That would be you. Now it is more important than ever to manage your own retirement funds responsibly to help you have the retirement you’ve always dreamed of.
That means being smart with your 401(k). One way to hurt your retirement success is to borrow against your 401(k). Sometimes it is unavoidable. But often times it can be avoided with proper planning.
So here are 5 ways that borrowing against your 401(k) can hurt you.
#1: You Probably Don’t Have A Pension – Don’t Sabotage Your Other Retirement Income Sources
When 401(k)’s became possible in 1978, this paved the way for employers to begin reducing and eliminating pensions. A pension is a type of defined benefit plan. The benefit (lifetime income) is defined. They must fund the plan sufficiently to pay this defined benefit.
That puts risk on the employer to fund pension obligations. You can see why they would want to get out from this obligation.
The 401(k) is a defined contribution plan. You contribute to the plan. The employer usually matches up to a defined percentage. The results of the investments are not the employer’s responsibility.
Since most people don’t have a pension now, it is more important than ever to be smart with your 401(k). It will serve as most people’s source of retirement income through smart investing and smart withdrawal strategies.
You don’t want to sabotage this account by borrowing against it during your working years.
#2: You’ll Probably Reduce Your Contributions if You Borrow Against Your 401(k)
If you borrow against your 401(k) you are more likely to reduce (or even eliminate) your future contributions for a time. This makes sense if you are paying back a loan.
Reducing (or eliminating) your 401(k) contributions can have a huge impact on your retirement. Contributions into a 401(k) are done automatically. They come out of your paycheck every 2 weeks if you have set it up for that.
People adjust their budgets to live with this lower amount of take-home pay. And the contributions get invested and are working to help out your future self at the point you retire.
Eliminating contributions also eliminates compound growth working in your favor. The longer your money has to work for you, the more it can grow. If you eliminate contributions for say 10 years, you are missing out on those years where you contributions could have been growing and compounding
And borrowing against your 401(k) increases the likelihood of reducing (even eliminating) your contributions.
#3: If You Leaver Your Employer You May Have To Pay Back The Loan Soon
When you leave your employer you usually have to pay back any outstanding 401(k) loans within 60 days. Changing jobs can be a stressful event. Why add the additional stress of having a loan come due within 60 days during this transition phase?
Also, if you got laid off due to corporate downsizing, is that really the time that you want to be confronted with a loan coming due in 60 days?
#4: Where Will You Borrow From If You Have a Serious Emergency?
Borrowing from a 401(k) should be viewed as a last resort. So treat it like that. Don’t borrow from it if you can avoid it. It’s not a piggy bank.
It’s always best to prepare for serious emergencies and then hope they never happen. Even 401(k)’s allow for hardship withdrawals under certain circumstances, such as unreimbursed medical expenses, withdrawals to prevent foreclosure on your home, and a few others.
But other options should be pursued before borrowing against a 401(k). Borrowing against it can have a huge negative effect on the amount of your retirement savings in the future.
#5: You Miss Out On Growth
There’s 2 ways you can miss out on growth by borrowing against your 401(k).
The first way is that most people will reduce or eliminate their contributions after taking a loan, as mentioned above. The amount of time contributions are reduced (or eliminated) represents time where the account misses out on growth. This could also cause the participant to miss out on employer matches to the 401(k) if they are not contributing.
The second way is you miss out on compound growth in the market while the loan is out. If the money is loaned out to you, then it’s not invested. Sure, this may have worked very well for people that took out 401(k) loans right before the 2008 market crash. But timing the market perfectly is impossible.
And people that are taking out loans against their 401(k)’s are usually not savvy with timing the market either.
Conclusion – Avoid the 401(k) Loan If You Can
Everyone comes across difficult times. And some people can’t avoid borrowing from their 401(k). But I hope you can now see some of the consequences of borrowing from a 401(k).
Also, it is wise to take steps today to put yourself in a better position to not have to borrow for emergencies. This means setting up an emergency fund. A good rule of thumb for people currently working is 3 months’ worth of expenses. If a hardship hits you, it helps to have that cash buffer.
Check out my free report “401k Rollover 10-Point Checklist.”