When a storm (or, well, hurricane) causes the electricity to go off and the store shelves are bare, we often find ourselves cracking open the pantry and making a meal out of whatever we can find. When stormy economic conditions are present—like nowadays—more and more people are doing the financial equivalent by cracking open their 401(k) nest eggs, and even more people are wondering whether that’s okay. The short answer is… NO!
The Most Expensive Omelet You’ll Ever Eat
When you dip into your 401(k), you are accessing some of the most expensive money you’ll ever touch. It basically comes down to getting a little bit of money now or a whole lot more later. Here’s the math: Let’s say you’ve got $10,000 in your 401(k). If you chose to cash out your 401(k), you’d pay both a 10% penalty and income tax. Using an “average” all-in federal, state, and local income tax rate of 25%, you’d wind up with a mere $6,500 left to spend—after forking over $3,500 (or 35%) to Uncle Sam. Now, suppose you’d left that full $10,000 in your retirement account and it grew at 7% per year for 30 years. You’d have nearly $60,000. That’s the choice you’d be making: to have $6,500 to spend today or $60,000 down the road. (Note: depending on where you live and your income, your total taxes plus penalty could approach 50%.)
“I’ll Bring It Right Back, Promise”
You may be thinking, “I just need the money for a little bit; why don’t I just take a loan from my 401(k)?” On the surface, this logic seems powerful. After all, if you’re borrowing money from yourself, you’ll pay interest back to yourself. But, if you lose your job, you’ll have to pay that money back immediately. Odds are very high that if you were in enough financial need to borrow this money to begin with, your only way to pay it back will be very high-cost credit card debt. Suppose you borrowed $10,000 from your 401(k) and then fell victim to a round of layoffs. Then you borrow $10,000 on your credit card at 15% interest to pay it back (because you have no choice). Making just the minimum monthly payments on that credit card will cost you nearly $7,000 in additional interest to pay back that $10,000.
Just Say No To Bad Savings Juju
The terms of borrowing from your 401(k) are usually as follows: There’s no credit check, you typically can borrow up to 50% of your plan balance with around five years to pay it back, and the interest rates are frequently set a few percentage points above the “prime rate.” There are three key problems with this:
- The money you withdraw will lose its ability to grow and compound. If you have a $10,000 balance, borrow $5,000, and pay it back five years later, you’d be out $2,000 of additional appreciation (if the market rose 7% in the meantime) PLUS the $1,250 interest you had to pay (assuming 5% interest over five years).
- You have to pay this money back with after-tax dollars. So, if your tax rate is 25%, you’d have to earn $8,333 to pay back the $5,000 plus the $1,250 in interest.
- It just gives you bad savings juju. Once you open that 401(k) door before age 59 1/2 you start down a slippery slope. Like trying to eat just one Pringle, you may find that once you pop you just can’t stop.
Bottom line: unless it’s a life or death emergency, just say no to cracking open that 401(k) nest egg.