During the height of the real estate market, my colleague, Cathy Moran, wrote an article called “A House is Not A Piggy Bank” that had real impact. It highlighted the mistake that many were making at the time. By borrowing against a growing (and as it trend out a phantom value), homeowners were financing an artificial bubble in the consumer economy. When that bubble burst, the economy fells from such heights that it may never recover.
The Washington Post has pointed out that more and more Americans are borrowing against their 401K accounts to finance living expenses. What a mistake! Let’s count the ways:
- How you take the money out of your 401K makes a difference. If you just withdraw the money, you have to pay taxes on it as if your were earning a paycheck. That is because this money was put into that account before taxes. As a result most people ‘borrow’ the money from their accounts.
- ‘Borrowing’ from the account avoids the tax problem, but creates several more. If you do not pay the money back, that tax problem comes back. If you lose our job in the meantime, you may lose the opportunity to ever pay the money back. Depending on your finances at the time, the new taxes can be an even greater burden that it would have been if you just withdrew it from the account in the first place.
- ‘Borrowing’ also creates another debt you have to pay. Since you are obligated to pay the money back, you have a fixed time in which to do that. Those payments become another bill when you might not be able to avoid another bill.
- As soon as the money comes out of your 401K account, it loses its magical quality of exemption. While it is in the account, it is not only exempt from taxes, butt it is also exempt from your creditors. Those retirement funds are protected by federal law. Once the money is in your bank account, it may be protected by your state law, but it depends on the state. In Connecticut, for example, only $1,000.00 of the money in your bank account is protected, but all of the money in your 401K is protected.
- Money in a 401K account is also exempt if you have to file bankruptcy. Would you rather get rid of your bills by taking money out the 401K and paying your creditors or would you rather keep that money for when you really need it and discharge your creditors through bankruptcy?
- Once the money comes out of your 401K, not only does it lose its exempt status, but since it is not there, it cannot continue to grow for your retirement years. Do you really think you can retire on Social Security money. Despite popular belief, Social Security was not meant to be a substitue for a retirement account or pension, it was only meant to be a supplement. How many companies do you know that pay penions these days? a 401K may be one of the only ways to save for that day when you cannot work anymore. Do you really want to be working when you are 80?
This same concept applied to the refinance craze. Consumers were refinancing their homes to pull growing equity out of their homes and agreeing to replay a 30 year mortgage when they were in the 50s. The same principles apply – do you really want to be paying a mortgage when you are 80 years old?
If you are truly in financial dire straits, it is understandable if you do not continue to contribute to a 401K account. You have to eat after all. But before taking that money out fo the 401K, take a minute to think about which would be better, retire with some money by discharging your debts in bankruptcy or paying those bills only to end up living in a cardboard box down by the river?
Last modified: November 17, 2013