The No Good, Very Bad 401(k) Move Americans Are Making

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Financial problems? Just borrow from the money you have stashed away for your future retirement.

Wait. Not so fast. In 2011, the Internal Revenue Service collected $5.7 billion in penalties after many people did just that, according to Bloomberg. In total that year, Americans withdrew about $57 billion from retirement funds before they were entitled to them.

In years past, people facing financial issues typically refinanced or took out second mortgages on their homes. But after the 2008 foreclosure crisis, many turned instead to their 401(k)s. The problem is especially significant among workers ages 20 to 39, as 41% cash out their funds when they change jobs, according to Fidelity.

While withdrawals from a retirement fund might seem like “free money,” there’s usually a hefty price to pay later on. In the U.S., a person who takes out money from a 401(k) account before age 59 ½ is hit with a penalty, and withdrawals are generally taxed as regular income, no matter the taxpayer’s age.

Compared to 2003, the government now collects 37% more money from early-withdrawal penalties, adjusted for inflation. In 2010, 9.3% of taxpayers with retirement accounts or pensions were penalized; in 2004, only 7.9% were.

The prevalence of early withdrawals is a problem not only because of the penalties taxpayers incur, but also because nearly half of non-retired Americans will eventually depend on retirement accounts as a major income source, according to a Gallup poll.

Unfortunately, there’s no perfect solution to this problem. One option is to lower the penalties for early withdrawals, though that might encourage people to take out more money from their retirement accounts. Alternatively, we could increase the penalties, which might discourage people from saving for retirement in the first place.

Thinking about borrowing funds from your future self? First learn the ins and outs of 401(k) loans so you can make an informed decision.