Why baby boomer parents should not borrow from 401(K) Plans

401(K) Plans
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The biggest fear facing every baby boomer is running out of retirement savings. The best way to address this fear of outliving your investments is to save as much as you can while avoiding early withdrawals and loans. But despite knowing this, more than 25% of the workforce is compelled to take some form of a loan or an early withdrawal when faced with a financial hardship. If you still feel that taking a loan from your 401(k) reserve is a less expensive way to overcome financial difficulties, these 6 facts will compel you to rethink:

You cannot make contributions until the loan is repaid

When you borrow money from your self-directed 401(k) plan, you are automatically forbidden from making any additional contributions until the outstanding loan amount is repaid. Since a 401(k) ensures a financially secure future, taking a loan against it is defeating your purpose of saving for retirement.

You are missing out on potential growth

Since you are not allowed to make any contributions, you are losing out on the potential growth you could have made with the balance you have accumulated so far. Also, every future contribution that you are not making right now is keeping you from growing your retirement reserve, which you may have worked really hard to get up and running in the first place, and perhaps even talked to professional retirement planning services to help you figure out exactly what your options were. If you now feel that you can take advantage of low interest rates, you’re probably unaware that even these low interest rates could be taking you to the cleaners with their tax implications.

You are losing both time and money

Retirement savings are long-term investments where your money grows over the time and most calculations suggest that your funds double every eight years. But, since you’ve taken a loan, there is no way you can make up for the lost contributions and grow your retirement savings.

You could invite a penalty and lose even more money

If for any reason you’re unable to repay the loan, it is treated as a withdrawal. To make matters worse, if you are under the age of 59.5, you invite a penalty on early withdrawal and your outstanding loan balance is subjected to income tax.

You cannot accept a good employment offer because you’re trapped

You have to continue your current job, as long as you don’t repay your loan even if better opportunities are calling out. So the scope of making a move for better prospects is zero. You can change your job only if you are willing to take the balance amount as an early withdrawal and also pay the 10% penalty.

You lose out on money that could come in handy when you really needed it

401(k) is designed to act like a buffer but since you have taken a loan against it, you lose your cushion. Your retirement savings should only be used in dire circumstances when all other funds have exhausted.

Borrowing from your savings suggests that you are living beyond your means and by doing that you are defying the golden rule of personal finance which says that you should be paying yourself first. So the next time you think of borrowing from your retirement savings, know that tomorrow you may not be able to fund the lifestyle that you are enjoying today.

What to do when you are left with no alternative

When you find yourself in a financial rut, what is the best way to overcome your immediate financial challenges? The right answer depends on your unique situation and several other factors. So it is best to consult an experienced financial advisor who is not only well versed with the general guidelines that govern loan plans but also knows what other options you have apart from borrowing against your retirement savings.

Certain employers offer retirement plans where the employees can borrow money from their pension accounts that work similar to bank loans. These plan loans don’t require credit checks and have favorable interest rates. However, these plan loans come with 3 broad conditions:

  1. The loan has to be repaid within 5 years
  2. All the repayments must be made using an equal level of amortization as there are no provisions for balloon payments
  3. The loan balance cannot be more than $50,000

The other option that you have is making a withdrawal. While a withdrawal will reduce the assets in your financial portfolio, you are not required to return it unlike a loan that must be repaid to avoid tax implications. It is not recommended to touch your self-directed 401(k), until you have considered other alternatives like home equity line of credit or your emergency fund. If you don’t want to face the consequences of failing to make payments, discuss your options with a financial advisor and know what suits you best.

Any leakage from your retirement plans whether in the form of a loan or an early withdrawal inhibits the potential growth of your long-term savings and keeps you from restoring your nest egg. So learn how you can maximize your retirement savings and retire confidently.   

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