You’ve been saving for years now, and your 401(k) balance is looking pretty good. It’s easy to think that taking a little money out here and there for a luxury vacation or a shopping spree for your summer wardrobe won’t hurt your 401(k). However, there are three good reasons not to take money from your 401(k).
Reason 1: You’ll Have to Pay up if You Leave
It’s said that the average American changes jobs at least 12 times during his or her career. While this is great news for your career, it can be bad news if you’ve taken money out of your 401(k).
Yes, withdrawing money from your 401(k) can help you afford larger purchases. However, any money that you take from your 401(k) if you plan on changing jobs must be paid back by the due date of your tax return plus any extensions. This can be a hefty price tag if you aren’t expecting it. Therefore, if you plan to leave your current job in the next few years or are expecting layoffs soon, it’s best to think twice before you take money from your 401(k).
Reason 2: You’ll Owe Interest
By law, you can borrow the lesser of $50,000 or up to 50 percent of your 401(k) balance. However, the money you borrow is subject to an interest rate. The interest rate is typically one to two points above the prime rate, depending on your 401(k)-servicing company. It’s wise to check with your 401(k) servicing company before you decide to take a loan so you can make a plan for how much you’ll owe each month.
A new tax law made 401(k) loans slightly more favorable for consumers. You will be required to pay back your loan within five years, plus interest, and pay at least quarterly payments. If you don’t pay your loan back within the five-year period, the outstanding balance is considered a 401(k) distribution. A distribution is subject to income tax and could also trigger the 10 percent early withdrawal penalty. Therefore, factoring in interest and your monthly payment before you take money out is a wise decision.
Reason 3: You’ll Miss out on Growth
Perhaps the most compelling reason not to take money from your 401(k) is that you’ll reduce your overall balance if you do not pay back your loan. Compounding interest is one of the best features of retirement plans and frankly why financial planners push saving for retirement as early as possible.
Quite honestly, compounding is the reason why saving for retirement in a 401(k), or another retirement account, is so attractive. Simply put, compounding is essentially interest stacking on top of interest to grow your account balance. Think about a snowball. The more it travels downhill, the more snow it collects and the bigger it becomes – the same can be said for your 401(k) contributions.
If you’re curious, there are tons of compounding interest calculators online that you can use to figure out what your account will likely grow to given a certain interest rate and monthly contribution. It would be wise to double check the impact of your 401(k) balance should you decide to take money out and not repay the loan.
A 401(k) is arguably one of the best ways to save for retirement. Many companies even offer contribution matching, aka free money, which is a great benefit to you if you have a 401(k) plan. Your 401(k) is an asset to you, no matter what your 401(k) balance is. It’s wise to spend some time thinking through a withdrawal to figure out if that decision is a good fit for your financial future.