Insurance 101

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  • Avoid 401(k) Borrowing

  • There’s no question that Americans are facing some tough financial times right now. As home prices continue to plummet and food and gas prices skyrocket, many consumers are tapping into their investments and retirement funds just to stay afloat.

    As a matter of fact, according to a recent Duke University/CFO Magazine survey, 20% of companies report that a growing number of employees are taking withdrawals and loans from their 401(k) accounts. Many of these workers are using the funds to cover their mortgage payments while others are attempting to dodge bankruptcy.

    However, some employees are simply borrowing from their 401(k) because they can’t secure a loan in the current environment. As lenders continue to tighten their standards, many consumers are finding it impossible to get a home equity loan to cover home improvements or other purchases.

    The drawbacks to 401(k) borrowing
    Although borrowing from your 401(k) might seem like a quick and easy way to get cash for those new kitchen cabinets, you will probably regret this decision in the long run. Financial experts warn that there are countless disadvantages to treating your 401(k) like a bank account.

    First of all, the 401(k) is the primary retirement saving vehicle for most American workers. If you remove money from this plan, you could be putting your dreams of a comfortable retirement at risk. Just think how many years you’ve worked to build up that nest egg — one big withdrawal can smash that egg all to pieces. Plus, you’re basically throwing away the compounded interest you would have accrued if you never touched the money.

    Not to mention that you could face some dire consequences if you don’t pay back the funds on time. Typically, when you borrow from your 401(k), you have five years to pay the money back via payroll deductions. Of course, you’ll also have to pay interest, which is often the prime rate plus an extra percentage point. These interest proceeds are tallied up as part of the balance you owe. So, in other words, you are paying interest back to yourself.

    But it gets even worse. It will obviously be difficult to continue making regular contributions as you are repaying your 401(k) loan with interest. However, if you stop contributing to your plan for even a few months, you’ll end up with significantly less money after you retire. Plus, if you aren’t contributing, you’ll be missing the boat on any match opportunities your company offers. That’s like missing out on a big bonus!

    You’ll face some steep penalty fees and taxes if you are unable to make your loan payments on time. If you happen to leave your current job, you’ll have to pay back the full 401(k) loan immediately — usually within 30 to 90 days. If you can’t pay off the loan in the specified timeframe and are less than 59 ½ years old, you might have to pay federal and state taxes on the money you withdrew as well as a 10% penalty.

    Taking a loan out from your 401(k) also means you’ll be burdened with double taxes. First, you have to repay the loan with after-tax money, and then you’ll have to pay taxes again when you withdraw the funds in retirement.

    An absolute last resort
    Considering the countless pitfalls, the lesson here seems crystal clear: Don’t withdraw money from your 401(k) unless you are in critical need of funds and have no other sources to tap. Taking a loan from your 401(k) should be viewed only as a last resort.

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