Step Away From That Growing Pile of Money

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.

Lost opportunity
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:

Time Period

At 8%, $10,000 Grows To

5 years $14,690
10 years $21,590
15 years $31,720
20 years $46,610
25 years $68,480
30 years $100,630

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.


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  • Report this Comment On June 17, 2011, at 11:20 AM, DDHv wrote:

    re food: a backyard garden has given us the best ROI of any investment. It also provides free outdoor exercise, and the food is totally fresh!

    In general, we've found keeping costs low and investing the savings to be the best pattern.

  • Report this Comment On June 19, 2011, at 9:16 PM, BenefitJack wrote:

    Sorry, this looks like something written by a mutual fund company; where many perceive 401(k) loans to be leakage as it is not assets under management.

    Your example misses the boat in three ways:

    (1) First, if the individual could consistently achieve an 8% annual rate of return on their investments, well, they are probably in the wrong job, and

    (2) Second, you fail to adjust for the interest the individual pays to her account as a condition of taking the loan, and

    (3) Third, you fail to note that too many have no easy access to credit as a reasonable rate.

    So, for those who have access to credit, maybe they would pay a bank 12% or more, or even use a cash advance, credit card or payday advance. In each situation, interest is generally not tax deductible - so you would prefer they earn 8% which, after taxes, is maybe 6%?

    The increase in loan usage in this recession may well be greater precisely because of the "credit crunch". Thank goodness they saved in the first place - most American's don't. Fact is, we would all be better served if we saved more than we feel they can afford to earmark for retirement - so that you and I can, if needed, borrow from ourselves, the so called "Bank of Selena” or “Bank of Jack”

    Loans are not leakage. Certainly, no one should take 401(k) loans lightly. But you do a disservice to your readers when you lump loans in with withdrawals. Simply, loans that are repaid are not leakage. Access to loans from your own 401(k) account have been shown by professional studies to actually increase participation and to improve your personal financial situation. And studies show almost all loans are repaid where employment continues.

    Caution advised. You are correct to caution readers to be careful when taking a loan. My rule of thumb is that you should not borrow the money from your 401k unless you could have borrowed the money from a commercial source. Similarly, I always recommend people arrange for a new loan from a commercial source (line of credit, etc.), just in case employment ends.

    Loans can add value. First, properly executed and repaid, a loan does not generate any tax consequences:

    (a) The transaction is not taxable, and

    (b) The nature of the underlying principal is not affected.

    Second, a loan does not reduce plan assets:

    (a) Assets remain in the plan, temporarily recorded as a different form of asset, and

    (b) Loan principal must be repaid with interest – you are re-building your account for a future, perhaps larger use.

    Third, studies show that loans that are repaid (where contributions continue otherwise unchanged), can actually increase account balances and improve retirement preparation. See studies by:

    (a) Geng Li & Paul Smith, which concluded: "... we estimate that such households could have saved as much as $5 billion in 2007 by shifting expensive consumer debt to 401(k) loans...."

    http://www.federalreserve.gov/pubs/feds/2009/200919/200919pa..., or

    (b) Beshears, Choi, Laibsen, Madrian, who state "... Although the popular press and politicians often describe 401(k) loans as a problem, classical economic theory has a more benign view. Loans from a 401(k) can relax liquidity constraints and increase household utility. Moreover, loan provisions may have the subtle effect of raising net asset accumulation by making 401(k) participation more appealing: employees who can access their 401(k) assets if they need them may be willing to put more money into an otherwise illiquid 401(k) account. Our research suggests that 401(k) loans are neither a

    blessing nor a bogeyman...."

    http://www.nber.org/programs/ag/rrc/08-09%20Beshears,%20Choi...

    The priority here should be to ensure loans are considerably more attractive than withdrawals and to update loan repayment processes to 21st Century standards (electronic bill pay, etc.).

    Finally, perhaps a first step should be to update 401(k) loan provisions to ensure loans are always superior to a withdrawal:

    (1) It is long past time for Congress to update loan limits - 50% of vested balance to maximum of $50,000 less the highest outstanding loan balance over the last 12 months. The $50,000 limit goes back at least to the 1970's - a time when $50,000 was probably greater than almost every participant's balance.

    (2) Use 21st century loan initiation and repayment capabilities (electronic banking) - not so much to make access easier but to make repayment more likely:

    (a) An ACH repayment process could provide access to loans and continued repayment even after employment ends,

    (b) Consider changing the loan structure to a line-of-credit so the amount borrowed can match the current need.

    (c) Use a true market rate to avoid lost or reduced earnings on investments.

    (d) Expand to include home equity/residence loans - to qualify for tax deduction of the interest you pay to your account and to encourage saving in 401(k) plans to facilitate home purchase and, upon repayment, finance retirement.

    Save, invest, borrow to meet the current need, continue to contribute and obtain the match, repay the loan to rebuild the account for a future, greater financial need. Repeat over and over until retirement.

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