We’ve all been there. Disaster strikes and you need cash, fast. PayDay loans charge on average 400% APR, and quickly spiral out of control and become too expensive and hard to repay. So what do you do? Many Americans opt to borrow from their 401k.
What is a 401k?
A 401k is an employer-sponsored retirement plan that allows you to use pre-tax earnings to invest. Employers who offer 401k plans will usually match a certain percentage of earnings, though sometimes they require you to “vest” or spend a certain amount of time working with the company before the matched funds become yours.
A 401k can quickly add up with your contributions, the matched amounts from your employer and the compounding gains the investment earns. Generally, a 401k is meant to mature with you and reach the desired goal when you hit retirement age. If you invest correctly, you will have a sufficient amount in your 401k to supplement your social security and live a comfortable retirement.
Why Borrowing From Your 401k is a Bad Idea
There are three big reasons to never borrow from your 401k:
- 401k contributions are tax-free, up until the point that you make a deduction. If you repay your 401k loan, it will remain tax-free until retirement. Usually, loans from a 401k can be up to $50,000 and require repayment with interest within five years. If you are unable to repay the 401k loan, you not only pay regular taxes on the amount but a penalty tax as well, currently 10%. If your financial situation is already unstable, the losses from this penalty tax undo the gains of the account, leaving you worse off.
- Loan interest is taxed twice. If your 401k requires interest to be paid on the loan, you pay that back with after-tax earnings. When your 401k matures, you pay taxes on your disbursements, effectively taxing you twice on the money you paid as interest to the loan. Though you are paying the interest to yourself, the money in your 401k will provide you more earnings if it remains untouched.
- You’re not investing in yourself. Too many Americans do not have enough saved for a comfortable retirement. When you take a loan from your 401k, you end up reversing the earnings you could be making. Closing the account is worse, the penalty is almost always higher than the taxes you would have paid on the money in the first place.
So What Do You Do?
The best answer is to leave the money in your 401k untouched and take steps now to provide yourself with other options should the need arise. Having a good credit score will allow you to take out a loan in an emergency situation with an interest rate that is low enough to make it an alternative to borrowing from your 401k.
If you have poor credit, a credit repair service can help you identify what steps to take to fix your credit. Good credit repair services not only help you fix your credit but also teach you best practices to ensure you maintain your high score. Good credit will give you better interest rates so when disaster strikes you can feel confident that you can borrow without penalty.
Do you need help repairing your credit? Download this free 7-step checklist that will give you the knowledge you need to start fixing your credit today.