Saving for retirement requires planning and diligence. Individuals should begin saving money early in their careers and they should be consistent about contributing to a retirement account. However, emergencies may occur that require cash and the account holder may be tempted to borrow money from the retirement account. This is not recommended because it has several financial drawbacks.
People justify borrowing money against their retirement accounts by telling themselves that they are borrowing money that is theirs and they are paying it back at a favorable rate of interest. While this is definitely a smarter alternative to cashing out of a plan entirely, it does have its drawbacks. These include tax ramifications and loss of earnings.
Not all retirement plans permit the investor to borrow from them. People are not permitted to borrow against individual retirement accounts, but some 401(k) plans do contain a loan provision. Plans that permit loans will usually allow participants to borrow 50 percent of the account balance up to a maximum of $50,000. Some employer sponsored retirement plans will not allow participants to contribute or will not fund the employer match during the period of the loan.
One of the biggest problems with taking out a loan against an employer sponsored retirement plan account occurs when the employee leaves the job. If the employee cannot pay back the loan in full, it is subject to income tax and a 10 percent early withdrawal penalty if the employee is younger than 59 ½. There will be less money in the account to benefit from tax-deferred interest compounding, meaning less money for retirement.
The purpose of a retirement plan is to save money for the post-employment years. The goal is not to set up a discretionary savings account and these accounts not be treated as such. Borrowing against a retirement account balance has tax and earnings consequences that will be felt long after the money is used to pay for whatever it was intended.