The idea of adequate retirement planning can mean different things to different people — especially when you consider lifestyle expectations.
But while there is no one-size-fits-all solution to retirement planning, there are definitely some basic dos and don’ts that apply to most people.
The cost of borrowing from retirement accounts
A whopping 96% of Americans have experienced at least one serious “income shock,” or an emergency that caused a drop of 10% or more in their pay. These shocks typically owe to a job loss or health scare, and when they happen, you need to be prepared with an emergency fund.
According to data from The Pew Charitable Trusts, more than 30% of American adults have borrowed money from their 401(k) or other workplace retirement account.
And while it may seem like a reasonable idea since it’s your money anyway and you plan to pay it back ASAP — the problem is, most people don’t — and tapping into that account can cost you big bucks down the road.
There are generally a few main reasons for “leakages” (withdrawals) from 401(k) plans:
- In-service withdrawals: Hardship withdrawals and withdrawals made after age 59 1/2, the age at which withdrawals are penalty-free.
- Cashouts: Typically when someone changes jobs, rather than rolling over their 401(k), they take the cash balance and pay penalties and taxes on it.
- Loans: When you take out a loan from your 401(k) to cover some other expense in life.
Borrowing from retirement accounts not only costs you a lot of money in fees and lost future savings, but it also establishes a pattern of behaviors that lead to even more long-term financial damage.
To give you an idea, here are some likely results of borrowing against your 401(k):
- You’re likely to reduce or stop contributions during the period in which you’re paying back the loan.
- If you do it once, there’s a 50% chance you’ll do it again.
- It’s your money, right? But you’re paying yourself back with after-tax money that will be taxed again in retirement.
- You miss out on potentially big gains on your investments during the time you’re paying back the loan (and likely not contributing to your account).
If this still isn’t enough to convince you that it’s a bad idea, these startling numbers might make you think twice.
The shocking numbers
Researchers at Boston College’s Center for Retirement Research analyzed data provided by Vanguard and the Census Bureau’s Survey of Income and Program Participation (SIPP) to figure out just how much borrowing from a retirement account can cost you in the long run.
The study was based on the following assumptions:
- An individual saves from age 30 to 60, with a starting salary of $40,000 and inflation-adjusted increases of 1.1% per year.
- The individual contributes 6% of his/her salary each year, with a 50% employer match. These investments earn an inflation-adjusted return of 4.5% per year.
- These savings suffer an average leakage rate of 1.5% per year, with higher leakage occurring earlier in one’s career.
The results: When it comes to the true value of investing, time is money — and this is especially true in this situation.
Since few people have the same job throughout their entire lifetime, the researchers created another hypothetical using the same data and the same sample individual.
Assume everything about the person in the example above stays the same, but in this case, assume the person rolled over his or her 401(k) into a Roth three different times — at ages 30, 40 and 50. The withdrawal rates in the study were based on the average IRA withdrawal rates for each age range.
The results of the study found that since about 1.5% of all IRAs and 401(k)s suffer some type of leakage in a typical year, for the average American, that results in a nest egg that’s $94,000 smaller than it would have been if the money were left alone.
What it means for you
While this is a hypothetical example, and doesn’t take into account the cost of any standard fees, it shows how big of an impact borrowing from your retirement accounts can have on your future.
Making retirement savings a priority when you’re young can be difficult — but having the mindset that you ‘can always save more later’ rarely turns out the way you planned.
Money saved now is worth a lot more than money saved later. If you’re strapped for cash, try to resist borrowing from retirement savings whenever possible. Here are some resources to help you pay off debt and increase your income:
- 6 ways to tackle credit card debt
- 23 ways to cut costs and save more each month
- 29 ways to make extra money each month
More ways to start saving more:
- How your spending habits impact your future
- Best way to save? Make it automatic
- How much a 1% increase in savings will pay off in retirement