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The all-too-common practice of borrowing from retirement accounts is much more dangerous than you probably think.
Almost a fifth of all American workers have borrowed from retirement accounts in just the past year, according to a Bankrate survey. That rate has roughly held steady for about a decade. It's a little hard to criticize the practice amid a long recession rife with rising prices and high unemployment. Most of the people borrowing are probably doing so to pay their mortgage or buy food, not to splash out on a big-screen TV.
Still, it's important to understand that when you raid your retirement account, you're disrupting the vital growth process of compounding. Those who take permanently withdraw money early from a 401(k) account or IRA face 10% penalties in addition to taxes owed. You may feel safer borrowing from a 401(k) account, because you typically have five years to pay the money back without incurring a penalty -- longer, if you use it to buy a home.
But borrowing remains a losing proposition. If you borrow $10,000 from your account, and then repay it after five years, it will have lost five years in which it could have been growing for you. What will you lose? Check out the table below:
At 8%, $10,000 Grows To
Source: Author calculations.
If your money would have had 25 years to grow, but ended up with only 20, it would have grown to just $46,610, instead of $68,480. You'd have lost almost $22,000. The table also shows you how powerful your earliest saved-and-invested dollars can be. Dollars you sock away just a few years before retirement can't do nearly as much for you as dollars you socked away a few decades ago. For the most powerful nest egg growth, aim to invest as soon as possible (even if you're not a spring chicken anymore), and as much as possible.
Borrowing from your 401(k) can particularly put you in a jam if you suddenly lose your job. You may have thought you had four more years to repay your loan, but suddenly, you only have a few months in which to do so -- or you'll face penalties for early withdrawal.
The big picture
When you're facing hard times, you have hard choices to make. While borrowing from your retirement account is an option to consider, you should try your best to find another way. You might have to take a second job for a while, or sell a car, take in a boarder, downsize your home, or even put college off for a year. If you're thinking of borrowing for a less-than-vital reason, consider that later on, you might really need the money, and it won't be there. Leaving your account alone will not only help it keep growing, but further ensure that it'll be there if some truly dire emergency strikes.
It can make sense to borrow from retirement accounts if you really have no other better choice, or if you know that it will be for a very short period and you'll be able to pay the money back. It's a simple and low-cost way to access cash -- but it can be disastrous if you don't handle it well.
Make smart decisions now, and you'll be in a better position in retirement, when all you might have to live on is your nest egg and Social Security.
Learn how to build a solid, growing retirement account here:
Longtime Fool contributor Selena Maranjian appreciates your comments. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.