The State of Retirement in the US and Borrowing Against Your 401k

Americans planning for retirement today have many concerns that previous generations did not have to consider. This country has gradually moved out of a tradition where most employers offered a pension plan. In effect, this has put a burden on individuals who must now fund their retirement savings largely on their own. This is just one concern that has created an unusual state of retirement in the United States.

Social Security Funding

Perhaps the biggest strain on retirement in the United States is the Social Security system. Ironically, the institution that was designed to help retirees maintain a viable income is the very same defunct system that has taxed the nation. The Social Security system has been running at an increasing deficit for several decades and has not reached the point where there is significantly less coming in than what is being paid out each month. America is quickly reaching the point where retirees are going to be primarily responsible for fully funding their own retirement.

Extending Retirement Age

One way to combat the lack of security within the Social Security income (SSI) is to work a few extra years. Thankfully, the advent of modern science and technology has improved the overall quality of life. Americans are on a healthier track and have an interest in eating well and adopting regular exercise plans. As healthy adults, Americans can delay retirement and continue working full time. Each year that SSI benefits are not taken can result in a slight increase in the monthly income when benefits begin. Many workers have opted to take this route and ensure they are receiving a monthly stipend from the US government.

Supplementing Retirement Income

Retirees are able to supplement their income in a few different ways. As previously mentioned, the SSI benefit provides a monthly income for retirees of a certain age. Personal retirement savings, such as qualified employer-sponsored plans and IRAs, are other common ways that people plan for their retirement. Other investment options such as stock trading and income bonds may provide additional funds for special projects. Some retirees supplement their income during retirement through part-time employment opportunities. They may work in a retail environment or pick up freelance opportunities doing what they love and making a little extra income for their golden years.

For many people, their 401k represents substantial savings. People might want to borrow from it for a variety of situations. Many finance professionals are against it. Each situation is different.

Some 401ks don’t allow loans. Many have hardship provisions in their charter. A quarter of people eventually make the raid on their retirement savings account.

Rules are constantly changing, but the government allows 50% of the funds, up to a limit of 50k, borrowed for five years. This loan is tax-free and has to be repaid gradually. The interest rate is usually very low. And the interest doesn’t go to any lender; it goes to you.

Some advice professionals recommend this route because it seems like a low-interest loan. But it’s often a poor idea.

Poor Math

One thing that’s often missed is the poor math. You made your original contributions with pre-tax money. You’ll need to pay it back with after-tax money. Therefore, paying back your loan will require significantly more capital.

Investment Return

You’ll indeed be paying yourself interest. But often, these returns will be a pittance compared to what your retirement savings could have earned in the stock market. Taking into account compound interest, your lost investment returns will be substantial.

If Unable to Pay Loan

The tax situation gets worse if you’re unable to pay the loan. The IRS will reclassify the loan as a withdrawal. You could be subject to taxation at your current income rate. There will also be an early withdrawal penalty. Often this is a punch to the gut to a struggling borrower.

Lose Last Financial Cushion

Let’s say times are not desperate (say you’re investing in a business). Your 401k is often the last possible asset to prevent financial disaster.

Poor Personal Finance

Often, the situation can be solved if you change your financial practices. Borrowing against your financial future is not smart if it’s because you’re spending too much on restaurants. This is especially true if you’re middle-aged because you’ll have less time to replace those savings. Older borrowers won’t be able to take advantage of compound interest as much.

Borrowing against your 401k can seem smart. There are some advantages. But often, it’s a poor financial choice. Tread carefully.