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Smart Women, Smart Money (6/15/17 Issue)

Consider Emmy’s advice before breaking open the piggy bank. – Courtesy photo


Dear Emmy, should I use my retirement account as a piggy bank?

By Emmy Hernandez

When the market is high, our 401(k) savings account statements, meant for retirement, look a bit brighter. Some people, hopefully, will choose to increase their monthly contributions to keep up the momentum. Others could be tempted towards the opposite: to take out a loan against their 401(k). The logic is somewhat sound. Why borrow from a bank or credit card when I can lend to myself, and most likely at a reduced interest rate? In practice, however, this strategy can be costly.

The funds borrowed lose out on the compound growth they could’ve earned. Even when repaid, removing money can create a permanent retirement account setback. This is referred to as the lost ‘Opportunity Cost’ and that, too, becomes compounded.

Because money is tight, many reduce or even cease their plan contributions during the loan’s duration. The newly diminished account balance now becomes stagnant. Any company matching program is also forfeit, further dwindling what would’ve been available during retirement.

Unlike plan contributions, which are made with pre-taxed earned income, any 401(k) loan repayments are made with after-tax dollars. Someone in the 25% tax bracket would need to earn $125 to repay every $100 borrowed. That can be perceived as a startlingly high interest rate. This same money is taxed again when withdrawn in retirement. Double taxation further magnifies the loss. 401(k) borrowers often cannot avoid these significant financial drains.

When a loan remains outstanding during a bull market, the lost opportunity can be significant. On the other hand, borrowing before a market plunge could help avoid some market loss. Accepting a loan should not involve such a blind gamble.

Retirement savings accounts weren’t constructed to be efficient lending tools. However, there are some situations when a 401(k) loan can be sensible if it meets these criteria:

  1. The loan is short term (about one year).
  2. The money is required immediately.
  3. The need is essential.
  4. All other avenues have been exhausted.
  5. Plan contributions are continued.
  6. A feasible repayment plan is followed.

A one-time, short-term emergency can be responsibly addressed under these conditions. But any debt that arose from systemic financial mismanagement or poor planning will very likely be exacerbated by a loan against a retirement account.

The primary concern when withdrawing from a 401(k) is the inability to pay back the loan. The inability to properly repay the 401(k) could cause the borrowed funds to be reclassified as a distribution. Prior to retirement age, unapproved distributions from retirement plans are not only taxable, they’re also subject to penalties. Plan participants could be forced to pay half of the borrowed dollar amount to the IRS if they’re unable to meet the loan’s terms. This is an extremely high price to pay.

401(k) loans aren’t always unwelcome, but they’re rarely the best course of action. Be sure to seek professional advice before making this decision.

Securities and Advisory Services offered through National Planning Corp. (NPC), member FINRA/SIPC, a Registered Investment Advisor. EH Financial Group, Inc. and NPC are separate and unrelated companies. NPC doesn’t give tax advice.

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