In debt and desperate? Whatever you do, don't do this
It can be tempting to borrow against your workplace retirement account when you're facing a mound of debt and can't seem to figure a way out.
Many employers offer the option to take a loan from your 401(k), but most financial advisers warn against it. Does it ever make sense to do it? After all, you are borrowing against yourself and repaying your retirement plan with interest.
Interest paid on the loan goes back into your account. Interest rates are usually lower than private loans too. So then why is it such a mistake to tap into this account?
Elizabeth Matthews Surmacz asked me this question on Facebook:
Due to recent financial hardship, we had to borrow from my husband's 401(k). We have bad credit due to medical bills and student loans. We felt we had to catch up on bills and Christmas for our kids. How bad a mistake was this?
Many people in Elizabeth's situation would see taking a 401(k) loan as a viable option. About one out of five 401(k) participants (21 percent) who were eligible for loans had loans outstanding against their 401(k) accounts at the end of 2012, according to the most recent data available from the Employee Benefit Research Institute. Still, most financial advisers agree that borrowing from your 401(k) is generally a bad idea.
"So you borrowed from your future retirement in order to pay for this year's Christmas shopping? Yes, it's definitely a mistake," says Greg McBride, chief financial analyst at Bankrate. "The root problem here is you are spending money you don't have, and you are stealing from your future selves to pay for it. Until you can figure out how to live within your means AND save for the future, your 'mistakes' are bound to multiply."
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One of the biggest downsides to taking out a 401(k) loan is that the loan amount can no longer benefit from the tax-deferred growth. You also now have to make loan repayments, which may reduce the amount that your husband can afford for salary contributions for now, especially if your disposable income is still stretched. He'll also have to repay the loan in less than five years from borrowing. If he doesn't pay it back on time, the loan will be considered an early distribution and, if he's younger than 59 1/2, you'll have to pay a 10 percent penalty plus state and federal income taxes. If he loses his job, the loan will be due within 60 days or he'll have to pay those penalties and fees.
But don't beat yourself about this misstep. You are on the right track. You just got temporarily sidetracked. The good news is that your husband had a 401(k) for you to borrow from in the first place. At least he had been putting money away for retirement. That takes discipline and that kind of discipline is the path to financial strength. What about you? Do you have a retirement account? Even if you're not working, you can contribute to an IRA. While you may feel too financially strapped to fit retirement savings for yourself into the household budget, consider it a necessity that should be factored into your household budget along with your other bills and expenses.
So for now, you need to stick to a plan to pay back the 401(k) loan and not resort to tapping that account again.
Follow these three steps:
1. Ensure that loan repayments are deducted automatically from his paycheck. This will help to ensure that the loan does not go into default as a result of missed payments.
2. Contribute as much as you can afford to his 401(k) account, up to the amount allowed under the plan. "Affordability is the key here," says Denise Appleby, CEO of Appleby Retirement Consulting and RetirementDictionary.com. "You don't want to contribute more than you can afford to, as that may force you to borrow to pay for your everyday living expenses."
3. If you still have outstanding debts, work with a financial adviser to figure out if it makes better financial sense to allocate more money to paying off those debts, instead of contributing to your 401(k) account. Adding to your retirement nest egg is important, but the benefits can be offset, or even outweighed by the interest you repay on high interest debts.
If you're having trouble hitting your retirement goals, worried about paying for college or paying off debt, send me your questions at yourmoney@CNBC.com.
You can also follow me on Twitter @sharon_epperson.