Don’t Mortgage Your Retirement Future with a 401K Loan
401k Loans Destroy Your Secure Retirement
5 Strategies to Avoid the Destruction
In preparing for a secure retirement we believe the provision for a loan is the absolute worst feature of a 401k.
Many Human Resource departments breathlessly promote this feature to reduce participant jitters that their money is trapped ‘forever’.
But the benefit of a few extra participants signing up due to the loan provision is tragically offset by those who ruin their retirement security by unnecessarily raiding their 401K.
Of course emergencies happen. But nearly all can easily be handled by a rainy day fund.
And research clearly shows that many reasons for 401k loans fall far more into the want than need or emergency zone.
Research conducted by TIAA-CREF on top reasons for 401k loans showed that 26% of respondents took a loan for a home purchase or renovation, 20% for education costs, and 15% for a wedding or vacation.
These three events, totaling 61% of all loans, can be planed for, and saved for, well in advance.
Any savvy wealth accumulator would agree that mortgaging one’s future economic security to live large today is a terrible idea.
Some will argue that what’s great about a 401k loan is that you pay interest to yourself.
While that’s better than paying someone else, that real issue is, to ensure a secure retirement, you must consider your retirement savings untouchable.
Picture your retirement dollars being sent in a small capsule to Mars, completely unreachable until retirement day, when it’s miraculously sent back.
The ugliest reality of a 401K loan is that many end up not being repaid. The loan just becomes an interim step to an outright withdraw. Taxes are then immediately due on top of early withdraw penalties.
Ultimately you ruin your retirement while yielding only $0.60 (or less!) on each dollar you rip out of the foundation of your financial future.
If you leave your job with an open 401K loan, it becomes due immediately.
A Wharton study showed that 86% who had open 401K loans when they left their job did not repay them. How tragic.
This means nearly all who face that circumstance don’t pay the loan off. They take the hit with all the fees and taxes instead, and at the same time undermine their efforts to build a secure retirement.
So how does one avoid the temptation to mortgage their future?
We believe there are 5 key strategies:
1. Consider Your Retirement Funds Gone Forever
When you initiate your retirement savings account simply consider the money untouchable under any circumstances.
Opening an account with the premise that it’s okay to raid it if you need it almost guarantees that it will eventually happen.
While it’s usually optimal to contribute at least to the level to grab the full employer match, if it’s so much of a stretch that you’ll almost certainly borrow against your 401K, you should reduce your contribution.
That may sound counterintuitive, but you’re better off having a smaller financial pool that you consider completely untouchable – and therefore it remains intact until retirement day — than a larger one that you’re likely to raid down to zero.
We all engage in various forms of mental accounting, some good and most bad.
Making your retirement account mentally untouchable is a good form of mental accounting that will serve to protect your retirement savings.
2. Make Sure You Have An Emergency Fund in Place
The temptation to initiate a 401k loan or outright raid your account becomes the strongest when you have an urgent need for money and you don’t have enough in your non-retirement savings.
The TIAA-CREF research showed 35% of respondents took loans to cover emergency expenses.
Some of those emergencies are likely just wants and needs, not real emergencies, and therefore can be avoided by living within your means (see next strategy).
And whether want or need, once the pangs of “I want it and I deserve it” hit the afflicted party, they go into cash seeking mode, and easily land on the juicy target of their 401k.
The reasoning goes something like this: “I won’t need the money for years or decades so, why not, I’ll pay it back quickly and even pay myself interest”.
A fully funded rainy day account will be your strongest defense against burning your retirement savings to cover routine occurrences like home maintenance, car repairs, unanticipated medical bills, home improvement, college, weddings, vacations and other such expenditures.
Another benefit of having a fully funded rainy day account is you will gain peace of mind that you can handle occasional financial storms without undermining your future.
This is turn can empower you to confidently increase your retirement and non-retirement savings to build the wealth you deserve and desire.
3. Live Within Your Means
Whether considering retirement or your overall financial security, most financial failures are due to living beyond one’s means.
When your outgo exceeds your income, regardless of the level of your income, you are guaranteed to never build meaningful wealth.
This concept is so important, we consider living within your means the very first retirement planning success driver.
When you’re living paycheck-to-paycheck you’re simply living too large, and even small financial bumps can become outright catastrophes.
So if you’re trapped in that vicious cycle, financial job #1 is to break the pattern.
Yes, it’s difficult. Yes, wages are stagnant and the cost of everything seems to be rising. It’s not your fault but it is your responsibility, because no one is going to bail you out and hand you a secure retirement you didn’t build.
Remember, Retirement Is All On You, so it’s up to you to take action to secure your financial future.
4. Delay Major Purchases Until You Can Afford Them With Non Retirement Funds
Retirement savings get raided for far too many expenditures that are simply wants, not needs.
First and foremost is borrowing to purchase a home. If you need to raid your retirement account to meet the down payment, you’re buying a home you simply cannot afford.
Rationalizations that residential real estate is a great investment are not based on reality. The Great Recession demonstrated the in no uncertain terms.
Even before the Great Recession, Robert Shiller, of the Case-Shiller Index, calculated that the return on housing from 1890 to 1990 was 0%. 100 years of data show owning a home is less attractive than a 5-year bank CD.
That’s not to say that buying a house is necessarily a bad lifestyle choice because for some, it simply makes sense.
But raiding your retirement savings to stretch into a home larger than you can afford is always a bad idea.
The next bad idea is to use retirement savings to spend for non-asset purchases like weddings, travel, cars, or home improvements. None of these will increase in value.
All of them will burn dollars whose power to generate more future dollars will be gone forever.
And while you struggle to make up for the damage, the memory of the wedding, trip, car or nicer basement will be either gone, or its happiness factor substantially reduced.
Finally, one that’s really tough: college education.
Of course you want your kids to get a great education. And you don’t want them to worry about huge tuition bills or massive lifetime loans.
But the time to prepare is when they’re young, and you have time on your side.
Raiding retirement funds to help with tuition is terrible in two ways. First, you substantially weaken your financial future. Second, the withdraws usually happen too close to retirement when you don’t have enough working years left to repair the damage.
I realize this sounds harsh, but you must seek a different solution or combination of solutions.
Perhaps a less expensive school. A part time job during the school year and full time in the summer. Doing the first two years at a local college so your child can live at home. Attending community college for the first few semesters. Having them take at least some loans.
Painful? Yes. Compromise involved? Yes.
But it’s important to find at least a partial solution in order to avoid destroying your retirement.
Simply raiding the account to help out may feel good at the time, but it can cause you financial misery for your entire retirement life.
The bottom line is that you must find a way to live within you means. If you can’t, you’ll never build meaningful wealth, including the savings necessary for a secure retirement.
5. Take A Traditional Loan If You Really Need To
I realize that many financial experts will say this approach is dead wrong. The fundamental reason they’ll cite, which is fair, is this: why should you pay someone else interest when you can pay it to yourself with a 401K loan?
The answer is this: you are far more likely to pay back a lending institution than your 401k loan.
You certainly have no temptation of not paying a bank back because they will remind you of your obligation and land heavily upon you if you don’t meet it.
But it’s far too easy to cheat yourself. And the costs are much higher.
By yielding $0.60 or less from an early withdraw, you are essentially ‘paying’ a 40% interest rate. Not only that, but you lose the fuel that will create more retirement wealth for you, for the rest of your life.
It’s like pulling logs out of a fire. It will get cold real quick.
So when faced with the temptation to raid your retirement savings, the first line of defense is to delay your expenditure until you save up for it and pay cash.
The second defense is to substantially scale back your want or need and pay with cash.
The third defense is to take a traditional bank loan to fund your scaled back need.
What should never be an option is raiding your retirement savings. 401k loans destroy your secure retirement. Just don’t do it. You’ll regret it for the rest of your life.