Don't treat your 401(k) like a piggy bank
Taking a loan from your nest egg could cost you more than you realize.
NEW YORK (Money) -- READER QUESTION: Many of my co-workers are borrowing from their 401(k) to pay for things like weddings, cars and vacations. They think that this is great because they are paying themselves interest. I'm a firm believer in not touching my retirement accounts. Which approach is right-mine or theirs? --Mony, Cheshire, Conn.
I'm always fascinated by the various rationalizations people come up with to justify almost anything they want. A $70,000 BMW SUV? That's not just ego gratification. It's a necessity for navigating those treacherously steep suburban driveways.
And spending $100,000 to transform a normal bathroom into a sybaritic palace with marble walls and a pool-sized hot tub isn't an extravagance. It's an investment in real estate!
Besides, if you can pay for all this by dipping into your 401(k), well, what's the harm? You're paying interest to yourself, so the more you borrow, the more you're feeding your 401(k), right?
Wrong. The idea of a 401(k) as some sort of easy-to-tap piggy bank is dangerous for several reasons.
First, just knowing there's an easily accessible sum in a 401(k) account can tempt some people to overspend. The money is just sitting there, after all, so why not put it to use? And with easy access to that money on a regular basis via loans, you could easily get the mistaken idea that you can live a grander lifestyle than you can actually afford given your income.
True, the fact that your employer will automatically deduct 401(k) loan payments from your paycheck does instill some discipline. You don't even have the choice of missing payments. But repaying the loan means you've got to get by on a smaller paycheck. That may make it tough for you to continue making contributions to your 401(k), or barring that, make it tougher for you to save for retirement and other goals outside your 401(k).
And a 401(k) loan is not risk free. If you leave your company while the loan is outstanding, most employers require that you pay it back either when you leave or shortly thereafter. If you can't, then the balance is considered a distribution, and you'll owe tax and perhaps a 10% penalty as well.
As for the notion that a 401(k) loan is a terrific deal because you're paying interest to yourself, well, that's overblown too. In fact, I did a column last year that compared borrowing from a 401(k) vs. taking out a home equity line of credit. My conclusion: you were better off with the home equity line even though you pay interest to a banker rather than yourself. For the reasons why this is the case, click here.
All that said, I recognize that there may be times when you really, really need something for yourself or your family and you have no other choice but to borrow. That's life. But when such occasions arise, I recommend that you begin by seriously thinking about how much money you truly need. Does the wedding have to be a fifty grand extravaganza? Can a modest used sedan do, or do you just have to have an expensive sports car or gas-guzzling belch-fire-eight-cylinder SUV? Would a modest road-trip vacation work instead of a jaunt to Europe?
Then look at alternatives for financing. If you can get a decent rate on a home equity loan or line of credit, a car loan or even a personal loan with a decent rate, you may be better off than borrowing from your 401(k).
If the 401(k) really is the only alternative - or clearly the best deal because the rate you would pay on the other types of loans is so atrocious - then fine. Sometimes you have to make compromises. But don't make a habit out of this sort of thing.
Although your attitude may mean denying yourself or scaling back a few indulgences during your career, I think you'll find it will pay off in retirement when you can afford to buy a new car or take the vacations that your formerly free-spending friends can't.