Unplanned expenses happen to everyone. And when you’re in a pinch, taking money out of your 401(k) can be a tempting option. But securing fast cash doesn’t have to derail your long-term retirement planning — 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 pulling cash out of your retirement savings can be the better choice for short-term money 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 a 10% penalty for early distributions if you withdraw money from your account.
In early 2018, Maurie Backman at CNN Money had a nice overview of the penalties people face when withdrawing money from a 401(k). She gives the example of someone who at 32 years old withdraws $10,000 from their 401(k) to buy a car.
That 401(k) retirement withdrawal is immediately hit with two costs: A 10% penalty, in this case $1,000, and taxes. Backman calculates that if that person has a 24% tax rate (i.e. another $2,400 expense), then she is left with just $6,600 to put toward 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 lose any interest you might have earned if that money were left untouched. Keeping that money in your accounts means keeping that interest compounding.
This is the flipside of Backman’s example above. If that 32-year-old car buyer leaves that $10,000 in her 401(k), that money would earn interest over decades. Let’s say that she ultimately decided on a 401(k) 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.
It’s true that if you make a hardship withdrawal from a defined contribution plan like a 401(k), you don’t pay the 10% penalty. But even then, you still lose the benefit of having that money being invested and building compound interest. The IRS limits the definition of a hardship for this purpose as medical expenses, permanent disability, loss of job and participation in a Substantially Equal Periodic Payment, or SEPP. And not all plans allow for hardship withdrawals.
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 terms of your 401(k), you’ll not only pass up some compounding interest, you’ll also have missed out on any employer matching funds for those contributions.
None of that happens when you avoid a 401(k) plan withdrawal. While the interest and any possible fees charged with a personal loan make you feel like you’re paying more up front, you may actually be saving in the long term.
Back to Backman’s example: If that consumer would simply take out a short-term personal loan, she would have access to the full $10,000 up front. And while she paid off the loan, the money in her 401(k) would be earning interest of its own.
A 401(k) isn’t a defined-benefit plan like corporate pensions. A worker gets out of a 401(k) only what he puts into it, plus a possible employer match. Money comes out of his paycheck, pre-tax, to be invested – typically in mutual funds. For most middle-class workers, it may be their best chance to invest in stocks, bonds and other securities and benefit from rising markets and compound interest.
4. You Can Preserve Your Job Flexibility
There’s the possibility of borrowing money from a 401(k) plan rather than withdrawing it. First, you must be enrolled in a plan that allows borrowing. The IRS says you can borrow up to 50% of your vested account balance, or $50,000 total – whichever amount is less.
The loan term typically is five years. If you don’t pay it back within five years, you’ll have to pay income tax on the account balance, and if you’re younger than 59 1/2, a 10% penalty. Keep in mind, your plan might not allow you to make new contributions while you’re paying back the loan.
If you change jobs or lose your job while the loan is in effect, you’ll have to pay it all back within a certain grace period or get hit with the taxes and penalty. Depending on your financial situation, you might have to pass up a good job to avoid the costs of paying off that loan right away.
As long as you can pay back what you’ve borrowed, short-term personal loans don’t place that type of restriction on their borrowers.
5. You’ll Avoid Forming a Habit
People who’ve 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 former Vice President of Market Insights.
You can avoid credit checks, application processes, underwriting and the approval period. The money is already yours, the interest rates tend to be low, and you’re paying the interest to yourself. But because of the potential for penalties and taxes, falling into the trap of considering your investment accounts “easy money” can be costly in the long run.
Why Is it Better to Use a Short-Term Loan?
While it may not seem immediately easier, borrowing might serve 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 in your retirement plan. The long-term financial impact will most likely be less damaging.
While retirement savings are easily accessible funds and it’s your money, it’s money that you’re saving for later – so keep it there. Failing to maximize 401(k) benefits might be the biggest mistake the average person can make in their personal finances.
Instead, form a healthier habit that’ll help you preserve the money you’ve been putting away 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 could 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.
This blog is for informational purposes only. Best Egg does not give or solicit investment advice.