Are You Stealing From Your Best Friend?

I talk a lot on this blog about the habit of saving money. This is for a good reason. I firmly believe that saving money is the cornerstone of financial freedom. It’s the starting point on the path to independence and a necessary habit for success.

You see, the way to get your money to work for you, is to take your savings and turn it into capital. Capital that can be invested to grow even more money. Therefore, it all starts with savings.

As we saw from the first Freedomation video a few weeks ago, Americans have a tough time saving money.  If that weren’t bad enough, there’s a new habit forming that’s making the savings problem even worse.

It has to do with early withdrawals from retirement accounts. To put it bluntly, early withdrawals from retirement accounts have become America’s new piggy bank.

For many years, Americans’ homes were their piggy banks. As home values increased, many refinanced or took out second mortgages. A lot of people got over extended with credit this way. That circus ended badly with the housing collapse of 2008.

Fast forward to 2014. Taking money from a 401(k) — and worrying about the consequences later – has now become the favorite method for Americans to steal from themselves. That’s right, they are stealing from their best friend, themselves!

A record number of Americans have been taking early withdrawals out of their retirement accounts in recent years. In 2011, the IRS collected over $5 billion in early withdrawal penalties alone. This means that Americans took out about $57 billion from their retirement accounts before they were supposed to.

How big is the problem? Adjusted for inflation, the government collects 37 percent more money now from early-withdrawal penalties than it did 10 years ago.

To put this into perspective, the median size of a 401(k) is $24,400 as of March 31, with people older than 55 having $65,300, according to Fidelity Investments.  I’ll put this as plainly as I can – those funds will disappear quickly in retirement.

What’s missing is longer-term thinking about the consequences of taking these loans today.  Treating your retirement accounts like a candy jar at Halloween can be the stuff of nightmares in the future. Here’s some things to consider before dipping into your 401(k):

Borrowing from your 401(k) can be habit forming. The way to look at your retirement account is that it’s sacred, something not to be touched except for emergencies. If you borrow from your 401(k) once, you might be tempted to do it again. It’s a slippery slope.

When you re-pay a 401(k) loan, it’s with after-tax dollars. Unlike the money you contribute to your 401(k) which is pre-tax dollars, the money you use to pay back your 401(k) loan comes from your after-tax income. Then it will be taxed again when you retire and start 401(k) withdrawals. That’s right, you get taxed twice!

If you don’t pay a 401(k) loan back, there can be steep penalties. Loan balances that are outstanding after the loan term expires (usually in five years) can be subject to federal and state income taxes and a 10 percent IRS penalty.

If you lose your job, you may have to pay the 401(k) loan back immediately. Under some plans, you must pay the loan back in full within 60 days of losing your job, or suffer those tax consequences and 10 percent penalty. That’s enough to keep anybody up at night.

You could lose interest earnings. If you borrow from your 401(k) you’ll be slowing the growth of your retirement fund, because the money you borrow won’t be earning interest during that time.  This is the opposite of planting seeds with your money. This is eating the seeds! It might not seem like a big loss now, but you’ll feel the pain when it’s time to retire.

Although it may seem easy to take a loan from your plan now, the long-term benefits of not touching your retirement savings may far outweigh the short-term benefits of taking the loan. Be sure to consider the impact a loan from your retirement account may have on your financial future.

After all, you want to be financially free in the future!