The following is a guest post about using your 401k to pay your bills. If interested in submitting a guest post, please read my guest post policy and then contact me.
May be Time to Think Again…
Picture this scenario…You’re 42 years old. Your company went through a reorganization last month, and as a result, your hours went from 40+ hours per week to 30. You were cut back from full time, and your occasional overtime is gone too. And now you’re sitting at your kitchen table, staring at a computer screen spreadsheet full of monthly bills and a budget. Your income level has gone from a little over budget to about 300 dollars in the hole each month.
You minimize your budget, switch screens and look at your savings. And there…like a big piece of double-layer chocolate cake, is your tempting and beautiful 401k balance. You’ve been piecemeal saving it for years. And you can’t believe you’re considering using it. Sound familiar?
As tempting and easy as it might be to take a loan against, or even cash out that pile of 401k heaven, stand up and step away from the table. Here’s a rundown of what happens when you take a loan against your own 401k, or cash it out early…plus a few alternatives that might work better until you can get a little extra income flowing again.
When you take out a loan against it…
Lots of 401k plans offer the option to take a loan out against your balance. Basically when you take a loan against your 401k, you are taking a loan from yourself, so think of this in the context of borrower versus lender. As a borrower (yourself) you want the lowest possible rate. As the lender (yourself) you want a higher rate.
Plus you have to consider how your money will financially fare if you don’t take out the loan and leave it alone in the 401k. No one can predict the future, but if you look at your 401k’s past performance, you can get a general idea. If your 401k historically has a higher rate of return than the interest rate of your loan, you could essentially lose money by loaning money to yourself at the lower rate. Other food for thought? You must pay back a 401k loan whenever the account is closed. So for example, if you are laid off, and your company forces you out of the company 401k plan, your loan will be due. If you find a better job, and in your job transition, you close your 401k plan, your loan will be due. It would be awful to decline a job just because you couldn’t close your 401k account and pay back the loan. So what about just not paying it back? It’s your hard earned cash anyway, right?
Well, then it’s considered an early withdrawal.
When you cash it out…
The government gets a big chunk of any part of your 401k that you decide to cash out early. You will have to withdraw much more than what you need to cover your expenses, because you’ll need to pay an early withdrawal penalty. Unless you can get a hardship, which is pretty specific, you will have to pay a 10% penalty for withdrawing early plus additional income taxes (which depend on your individual tax bracket) on that withdrawn money. For example, say that you withdraw $20,000 early. You will have to pay $2,000.00 (the 10% penalty) of it to the government right off. Plus if you are in the 22% tax bracket, you will pay an additional tax on the withdrawal as income tax. You will be left with under $14,000.00 of that $20,000.00 hard earned cash. With those percentages, 32 cents of every dollar in your 401k will go to the government in taxes and penalties. Plus you will forfeit the general fact that the money is earning money now for later.
It’s a pretty ugly loss.
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So what to do instead?
First, take a few deep breaths and sit back down. Switch over to your first computer screen and review your budget. I mean REALLY scrutinize it, and seriously think about what you can do without or suspend until you get another job or some other income. See if you can bring your family into a position where you are living within your means, yet on a reduced income. It might not be comfortable at first, and it will definitely be a change. But, you might realize things you never knew you could live without, and lower your monthly nut, too! And that’s a good thing – job or no job.
Second, chances are your house and your car expenses are large parts of your budget. Sometimes student loans rank right up there too. Think about calling your mortgage company about a refinance. You might also contact your student loan company, if this is part of your budget, and discuss options with them. Many times, student loan lenders have repayment, forbearance, and deferment options that can help with short-term financial issues.
Loaning against or cashing out your 401k might not be the best way to go if you’re thinking about paying off your debts or supplementing monthly income. With a little bit of scrutiny and willingness to makes some calls and changes, you might find your budget and your retirement will thank you later.
Author Bio: Paige Estigarribia is a writer for The Dollar Stretcher, a long-running financial and frugal living website. For more information about 401k plans, check out The Dollar Stretcher’s articles on the basics of 401k plans as well as orphaned 401k plans and 401k rollovers. To get additional information about 401ks and retirement, visit The Dollar Stretcher library.