Many Americans facing financial difficulties see borrowing from a retirement account as a reasonable solution. When you borrow from your retirement account, you pay yourself back with interest. While this is a tempting thought, you should realize that there are consequences to borrowing from your nest egg that go beyond paying penalties if you don’t repay the loan on time.
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Lost earning opportunities. It’s not a good idea to borrow from your retirement account, even if you meet the 401(k) hardship withdrawal rules. When you withdraw money from your 401(k), you are violating the rule that your money should be working on your behalf. Once that capital is gone from your account, it is no longer earning interest for you. Even if you replace the principal, you can never replace the missed earning opportunities. With that money missing from your retirement account, the earnings on your portfolio are smaller, since the principal is smaller. This is time that your money cannot recapture.
Many people also stop their retirement account contributions when they borrow from their retirement account. This means that, not only have you reduced the interest-earning power of your savings, but you have also stopped adding more money to your account to further boost its growth. Instead of putting your money to work for you, you are using your money elsewhere, and that can hinder your ability to achieve your retirement goals.
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Without compound interest working on your behalf during the time that you have removed money from your retirement account, you could fail to accumulate a significant egg. Before you borrow from your retirement account, it is a good idea to consider all of your options and the damage you could be doing to your long-term financial goals.
Borrow wisely. Sometimes you really have no other option. You have to get cash from somewhere, and your retirement account costs less than credit cards and other loans. Plus, you are borrowing from yourself, rather than from someone else. If you do borrow from your IRA or 401(k), it is a good idea to follow some rules:
- Borrow as little as possible. Take out only what you need. Do not take extra money.
- Repay yourself as quickly as you can. You might get years to pay back your retirement account loan. But the longer you have less in your account, the smaller your long-term earnings will be. Pay back the loan as soon as you can so that your principal can start working for you again.
- Keep making contributions. Depending on why you are borrowing, you might be able to continue making contributions. If you can keep saving in your retirement account after withdrawing some of the money as a loan, do so. Continuing to add money will help reduce the impact of lost earning opportunities.
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Borrowing from your retirement account can sometimes be necessary. But it is a good idea to think twice about raiding it for any reason.
Jeff Rose is a certified financial planner and U.S. combat veteran. He blogs at Good Financial Cents and Soldier of Finance.
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