Borrowing money from my 401(k) sounded like a good idea when I needed to purchase a new vehicle. Interest rates at that time were much higher than they are now. To me, it seemed as though I was only borrowing money from myself. Some financial experts, though, say taking such loans is essentially stealing from my own retirement. According to a new study cited by the St. Louis Post-Dispatch, many people have defaulted on their loans, which costs in terms of taxes and penalties for the borrower is as high as $37 million a year.
The article points out that 20 to 30 percent of people who participate in a 401(k) plan take out a loan. I personally believe the government should lift the 10 percent early withdrawal penalty during down economic times. I don't understand why there is a penalty to access the money at all as long as the person pays the taxes owed on any profits.
Building up an emergency fund
The No. 1 reason I tapped my 401(k) was because I lacked an emergency fund. Since my last 401(k) loan, I have been saving money for the future in a savings account. Having a fully-funded emergency fund gives me a sense of security. Of course, everyone has a different idea of how much they need to put aside for emergencies. Since I have about $50,000 in my 401(k), I am trying to save up $25,000 in an emergency fund or half of what's in my retirement account. I'm only allowed to borrow half of what's in my retirement account so I feel as though this is an equivalent safety net.
Taking the shortest possible loan
Another way I weaned myself off the habit of relying on 401(k) loans was by taking the smallest possible length of a loan. I found taking a shorter loan reduced my pay check so that I had to give up all fun, discretionary purchases. After one year of having no entertainment budget, I felt motivated to stick to a budget that included saving for a rainy day.
Reducing my contribution
After thinking about the kind of lifestyle I want when I retire, I realized I wouldn't need millions of dollars saved. I realized I had been contributing too much to my 401(k) plan at the expense of other savings goals. I needed to have a college savings fund, a new car savings fund as well as the standard emergency fund. Instead of contributing 20 percent of my income to my employee-sponsored retirement account, I cut back to 10 percent. Now I don't have to worry about paying a 10 percent penalty to access money I need years before retirement.
Some people have suggested that there should be a ban on borrowing from a 401(k). I know if I wasn't allowed to access money in my retirement accounts, I'd be completely unmotivated to save for retirement. That's because I'm almost 30 years away from retirement. Statistically, I may not even make it to retirement. With all the layoffs and economic uncertainty, my solution is to be stay as far away as possible from any kind of loans or debt.
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- Banking & Budgeting