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by Erienne Andvik

You're young and you've been slogging through a tough economy. Bills, rent or mortgage payments, car payments, insurance, credit card payments, school loans, and other expenses—even the exorbitant cost of going to or being in a wedding—create a lot of fiscal pressure.

If you're in your 20s, chances are you won't retire until after 2050. You've got a retirement account, but are struggling to balance your budget in your day-to-day life, so what's the harm in borrowing from your retirement stash to get you through?

cons outweigh bennies

The harm in borrowing from a retirement account may be much worse than you think, potentially jeopardizing your current financial state and postponing your retirement age. Research shows that even a small loan of $5,000 reduces your future nest egg by between 13% and 22%.

Borrowing from a retirement account is rarely advisable. Here are three reasons why:

1. Potential for lost contributions. Some employers won't let you make contributions to retirement accounts while you have an outstanding loan. Think back to Econ 101 and opportunity cost. Steve Rick, senior economist at the Credit Union National Association in Madison, Wis., boils it down: "Withdrawing any amount of money at any time reduces your principal." Then you further reduce your principal by not making contributions during the payback period. Rick says, "When you have less principal, you earn less interest."

For example, let's say you normally would contribute $400 a month, or $4,800 a year, to your 401(k), and your employer contributes 50 cents for every dollar. Suspending your contributions would cause you to miss out on $2,400 in employer contributions in a single year—or $12,000 over the five-year loan repayment period. And that significant loss does not even include foregone investment earnings on the money over that period.

Even if your employer lets you make contributions to your retirement account while you have a loan, it will be difficult to maintain the same contribution level when you're also paying back the loan.

2. Tax implications. When you contribute to traditional retirement accounts, contribution money is withdrawn from your paycheck before taxes. If you take a loan from your retirement account, you'll have to pay back the loan with money from your paycheck—money that already has been taxed. For example, if you borrow $10,000 from your 401(k), you'll have to pay more than $10,000 plus several thousand dollars of pretax income to get back to $10,000 after-tax income. The actual amount will depend on your salary and corresponding tax bracket.

Additionally, your retirement income will be taxed when you withdraw money in retirement, so you'll be hit twice.

3. Losing the value of compounding interest. When you contribute to and leave money in your retirement account, it earns interest. When you borrow from your retirement account, you stop earning interest on the money you've borrowed because you've reduced the principal amount that earns interest. If you take a few years to pay back the loan, that's several years of lost interest, which means it will take you longer to reach your financial retirement goals. That could mean you have to work more years than you planned.

To drive this home, say you are 30 years old, in the 25% tax bracket, and want $10,000 to pay for your tuition this year. To net $10,000 and pay the employer withdrawal fee and the IRS early withdrawal penalty plus taxes, you'll need to pull $15,485 from your retirement account. For the next six months you can't make any elective deferral contributions, and you'll miss your $2,700 employer's match. That's $18,185 that won't earn compounding interest—for the next 35 years.

Assuming you miss a 7% annual rate of return, you will come short roughly $194,000 when you retire. The shortfall will be even more if you're younger at the time you make the withdrawal. This loss of retirement funds will mean that you might have to continue working longer than you expected.

It's hard to pay yourself back when there's the mentality that you can always do it later. Rick says, "Even if you borrow money from your retirement and pay it back in a timely manner, it's easier to borrow from yourself a second time, and it's a bad habit."

Retirement loans can have tricky stipulations. Unfortunately, if you voluntarily or involuntarily leave your job, you're generally required to pay back loans within 30 to 90 days. It may be difficult to come up with the money on short notice—especially if you didn't choose to leave your job. If you aren't able to pay back the loan in that timeframe, the loan will be treated as regular taxable income and will result in an additional 10% early-withdrawal penalty as long as you're younger than 59 1/2.

alternatives to borrowing from your retirement

Many high-priority expenses can take a big bite out of your budget, but there's almost always an option to borrowing from your retirement funds. If you have a spending plan, review it and determine what you can cut. Reducing your spending instead of taking out a loan is always preferable. If you don't have a spending plan, create one—then track your spending closely so you adhere to it.

There are times when you really do need an additional chunk of change, whether that's for a car, toward a down payment on a house, to pay off high-interest credit card debt, or whatever else it may be. When you need to borrow money, the professionals at your credit union can help with the right kind of low-interest loan that will meet your immediate needs and won't damage your financial future or delay your retirement.

Published March 26, 2013

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