The Real Cost of Dipping Into a Retirement Account

More people are taking loans from their retirement accounts (401(k), 403(b), etc.) than ever, simply because they can. Here’s the problem: seeing one’s retirement account as a savings account, or worse, a personal ATM machine. That’s so ridiculous I cannot even tell you. Sure, it’s your money, but it’s not your money now. It’s for later. It is out of your reach, so you need to get it out of your mind.

The beauty of an IRS-approved retirement account is that you get to save pretax dollars. It’s no secret that what you see in your paycheck is not the full amount you earned.

In fact, the amount in your paycheck is shrinking, and many of our elected officials are trying to shrink that even further by increasing taxes. You know what I mean if you live in California — one of the most heavily taxed states. (Did I mention my husband and I left California for this very reason?) But I digress.

A retirement account allows you to save your money before it gets taxed. If you take your money home, you have to earn about $1 to see 75 cents in your paycheck. But if you put that dollar into a retirement account instead, you get to deposit the entire $1. You get to invest the 25 cents that belongs to the government. It’s not a gift; you will have to pay that 25 cents to the government eventually. But for now, you get to keep all the growth you will achieve by investing the government’s money! Get it? And it’s all locked up, so it is safe from YOU. That’s the beauty of a retirement account.

Now, if you go and stick your hands in there and borrow some of that money, you really mess things up. There are rules, conditions and penalties for doing that. But the biggest penalty of all is that you stop the machine that makes those dollars grow. Sure, it can be slow growth as we are experiencing now, but it’s growth, nonetheless.

There are lots of reasons not to borrow from a retirement account, but I think the biggest is the rule that should you leave your job for ANY reason, that loan becomes all due and payable. You’ll have a couple of weeks to come up with the money. And if you can’t? That loan will be automatically converted to a cash withdrawal. Between the penalties and taxes you will owe on it right away, it could cost you up to 50%. Gone. Vanished into thin air. That is just too risky.

Here’s an example: You borrowed $15,000 from your 401(k) for your daughter’s wedding. You felt OK about that since you immediately started a repayment plan that includes interest to yourself.

A couple of months later, you got a pink slip — a shocking, unexpected layoff. You get a notice that you have 14 days to come up with the entire amount owing, which is $14,650. You can’t do it!

The plan’s administrator immediately converts that $14,650 to a “cash withdrawal.” BAM! Just like that you owe 10% penalty on the entire $15,000. Then the entire $15,000 is immediately reported to the IRS as ordinary income upon which you owe federal and state (if any) income tax. Your federal tax rate is 28%, and since you live in California you must also pay 10% to the state. Do the math: 14,800 x (10% + 28% + 10% = 48%) = $7,200. That’s what you owe in taxes. Can’t pay? Then you’ll have to agree to a payment plan with the feds and the state tax board — plus interest, of course. Ka-ching!

Whatever will you do? You don’t have a job; you can’t afford the bills you have already. How will you take on two more monthly payments to creditors who are anything but understanding, kind and forgiving, should you fall behind?

Thankfully, this was only an example. Whew! You still have time to reconsider taking a loan from your retirement account. Here’s my suggestion: Don’t! Do not even think about it. The money in your retirement account will become your safety net in the future. Live as if the money is not even there. Just save it and forget it.