Why Taking Money Out of Your 401k is a Bad Idea & How Short Term Personal Loans Can Help You Avoid It

Unplanned expenses happen to everyone. And when you’re in a pinch, taking money out of your 401(k) can be a tempting option. Yet securing fast cash does not have to divert your long-term savings plan—especially when there are other options out there like short term personal loans. You’ve probably heard this before, but keeping your retirement intact is one of the best practices of personal finance.

Here are five reasons why choosing a personal loan over cashing out your retirement savings can be the better choice for short-term capital needs.

Why You Should Take Out a Personal Loan Over Pulling from your Retirement

1. You’ll Skip the Penalties and Taxes

For many kinds of retirement accounts, (including 401(k)s, IRAs, and Roth IRAs) the 59½ rule is hard to ignore. If you’re younger than 59½, you’ll most likely have to pay 10% on a withdrawal from your accounts.

In early 2018, Maurie Backman at CNN Money had a nice overview of the penalties people face when withdrawing money from their 401k. She gives the example of someone who at 32 years old withdraws $10,000 from their 401k to buy a car. That 401k retirement withdrawal is immediately hit with two costs: A $1,000 penalty and taxes. Backman calculates that if that person has a 24% tax rate (i.e. another $2,400 expense), then they’re left with just $6,600 to put towards the car. The rest goes to penalties and taxes.

2. You Won’t Miss Out on Earning More

One of the biggest advantages of retirement accounts is compounding interest. If you take money out of one of these accounts, you can lose any interest you may have earned if that money was left untouched. Keeping that money in your accounts means keeping that interest compounding, at that growing value.

This is the flipside of Backman’s example above. If her 32-year-old car buyer were to leave that $10,000 in rather than withdrawing funds from her 401k, that money would earn interest over decades. Let’s say that consumer ultimately decided on a 401k plan withdrawal at 59½ years old, right when the early withdrawal penalty ends. At an interest rate of 4.25%, that initial $10,000 at age 32 would be worth more than $29,500 at age 59½.

In other words, our borrower could either turn $10,000 into $6,600 cash by withdrawing now, or into $29,500 later by leaving that money alone.

 3. You’ll Save More in the End

IRAs have contribution limits, so even if you pull out, it can be difficult to replace that money. And depending on the payback terms of your 401(k), you’ll not only pass up some compounding interest, you’ll have missed out on any employer matching for those contributions.

None of that happens when you keep it all in place by avoiding 401(k) plan withdrawal. While seeing that interest rate on a personal loan may feel like you’re paying more upfront, you may actually be saving more in the long term.

Go back to Backman’s example. If that consumer would simply borrow short term personal loans, they would have access to the full $10,000 up front. And while they paid off the interest on that loan, their money would be earning interest of its own in the 401k account. That’s why borrowing from yourself is often much more expensive when taking money out of a 401k.

4. You Can Have Easier Job Flexibility

If you do borrow money from your 401(k), that loan still exists even if you wish to change employers. This means that for most people who take out a 401(k) loan, their only option is to stay with the same employer until after the loan is repaid. As long as you can pay back what you’ve borrowed, short term personal loans don’t usually have those restrictions on their borrowers.

5. You’ll Avoid Forming a Habit

People that have borrowed from their 401(k) once, are more likely to borrow against it again, according to a Fidelity study of more than 180,000 borrowers. “They find it’s probably easier than going to the bank to get a loan, so it becomes a bad habit,” says Jeanne Thompson, Fidelity’s vice president of market insights.

You can avoid credit checks, application processes, underwriting and the approval period. The money is already yours, so you are guaranteed to have access to it. But because of all the penalties, fees and taxes, falling into the trap of considering your investment accounts “easy money” is costly in the long run.

Why is it Better to Borrow a Short Term Loan?

While it may not seem immediately easier, borrowing serves as the smarter option for fast cash when you need it. You will have to pay interest on the loan, but you won’t miss out on any earned interest from your retirement. The long-term financial impact will most likely be less damaging, and you may be able to borrow more than what you’ve invested.

While retirement savings is easily accessible funds that is your money—it’s money that you’re saving for later, so keep it there.

Instead, form a healthier habit that will help you keep the money you’ve put aside for retirement, and create new wealth opportunities for yourself right now. Though it may be more work to secure a short term personal loan, it can leave you in better financial health, while allowing you to stay on track to accomplish your retirement goals.

You have options. You can make it. Take advantage of what’s out there and choose what’s right for you.

Disclaimer:

This blog is for informational purposes only. Best Egg does not give or solicit investment advice.

For more information about retirement accounts visit IRS.gov. For interest calculators and other financial planning tools, visit Investor.gov.