Throughout my years, there have been several times that I rationalized borrowing from my 401k as a satisfactory money management method. As dumb as that may seem, I’ve seen dumber.
I remember hearing, once, that someone I know who was in their early 40’s had emptied out their 401k. It was an emergency. Their car had broken down and they needed the money to buy a a new one – a nice new car that they obviously couldn’t afford.
I couldn’t believe how stupid they could be!
Of course, he had to pay tax on the money he withdrew. Plus, since he wasn’t retirement age, he had to pay penalties. By the time it was all said and done, he had blown about $35,000 on $20,000 worth of depreciating asset…a car.
Several years later, all he had left was an old worn out car and no retirement savings.
My 401k Borrowing Experience
A few years ago I borrowed funds from my 401k. It wasn’t the first time I’ve done that. In fact, over the past 25 years, I’ve borrowed from my 401k about four or five times. It’s been a go-to source for funds that have gotten me out of a few difficult financial places. It was always comforting to me, knowing that I’m forced to replace/pay back the funds to my 401k with interest – at least, that’s how I’ve rationalized using my 401k as a source of funds for current expenditures. It’s better than paying interest to the bank, right?
Despite the benefits of borrowing from yourself, instead of from a lending institution, I realize now, more than ever before, that it can be one of the stupidest money mistakes a person can make. Maybe not as stupid as withdrawing the funds and paying penalties, but stupid, none the less.
I’m coming up on the final payoff date of my most recent loan, so I’ve been looking at some options of what I might do with the extra portion of my income that I’ve been using to pay back that loan each paycheck. It’s exactly $554 per month that I’ll have available, so it’s not just some insignificant amount, to me. It can make a big difference in my life in one way or another.
What are My Choices After My 401k Loan is Paid Off?
Buy something – My wife and I have wanted to get a travel trailer for a long time. With this money, we could afford to purchase one on credit and with this new money we have available to us, we could easily make the payments on the loan. But, my goal is to pay cash for that. I’ll feel better about myself if I wait.
Pay off credit card debt – I’ll still have some credit card debt when those extra funds become available, so it might make sense to add that money to my debt snowball. That’s what Dave Ramsey would encourage me to do. But, I took advantage of a 0% promo offer awhile back, so I’m not paying interest on that debt. If I was stuck with 15% or 18% interest on that debt, I would certainly want nothing more than to accelerate those payments. With 0%, I’m not as motivated to do that.
I get promo offers just like that almost every day, so I have the option of doing that over again if I haven’t paid it off by the time the promo expires. The most I ever pay on those is the 3% balance transfer fee. I’m not too worried about stretching that out a bit longer. I’ll get it all knocked down in due time.
Keep paying into my 401k – I put together a quick little spreadsheet to consider the tax implications of continuing to add the funds into my 401k. I’ve already been putting that money into my 401k in the form of loan repayment, so my budget wouldn’t be affected much. The only difference is that putting money in my 401k in the form of a loan repayment uses after-tax money. After the loan is paid off, I can continue with the same deposit with pre-tax money.
What do you think makes the most sense?
I’ll tell you what I think. Doing the 401k thing gives me the most bang for the buck. In fact, it’s like giving myself more than a $100 per month pay increase. Let me explain.
As I suggested above, even though the money you invest in your 401k goes in pre-tax, the money you put in your 401k to pay back a loan goes in after-tax. After the loan is paid, and I start investing my money into the account, instead of paying back a loan, my payroll taxes will decrease by a fairly significant amount. In fact, when my loan payment is done, I can continue to invest that $554 into my 401k each month, plus add another $45 to that, and still end up with about $65 more per month in take-home pay.
Did you get that? I will have an extra forty-five dollars going into my savings each and every month, and will still have an extra sixty-five dollars each month in take home pay. That’s kind of like giving myself a $110 per month pay increase. How cool is that? That’s the power of tax-advantaged savings.
I guess I know what I need to do.
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