Let me share a story with you. Tom and Jane are a Millennial couple who just got married and are looking buy their first house. The have saved up some money but have student loan debt. Unfortunately, Tom just lost his job leaving them with only Jane’s income to pay the bills and the loans. While he is looking for a new job, they have to partially live off the money they have saved but it only goes so far. To make ends meet, they wonder if they should take a loan from Jane’s 401(k) to help cover their expenses and pay back the loans. What should they do?
I hear it all too often: Millennials saying they need cash to fund a purchase or pay down debt. It’s a tough problem because many Millennials are cash-strapped from years of a poor economy and slow job growth as well as student loan debt. I don’t like seeing Millennials in an emergency need of cash and having limited options of where to get it from. Needing last minute funds is a sign of poor cash management. Emergencies happen. It’s part of life. In Tom and Jane’s case, they didn’t anticipate losing an income source, but did they do all they could to plan for a financial emergency? Is taking a loan from a 401(k) the right decision?
Let’s talk about 401(k) loans
If you are lucky enough to work for a company that has a 401(k), congratulations! (Side note: these can be great retirement savings vehicles and if your company offers a matching contribution, it’s like free $$$). If you do have a 401(k), many offer the ability to take a loan. Let’s look at the Pros and Cons of that loan:
- Most will allow you to borrow half of your vested account balance up to $50,000 and are usually paid back over 5 years. If you are borrowing to purchase a primary residence it might be a 10-15 year period.
- They are relatively easy to obtain with some simple paperwork through your 401(k) plan provider.
- These interest rate on the loan is determined by the plan but usually prime rate plus 1-2%.
- Payments can sometimes be deducted from your payroll checks automatically.
- If you can’t pay back the money you borrowed, the unpaid portion is subject to ordinary income tax and a 10% early withdrawal penalty. Say bye, bye to that money.
- If you leave your job, your plan may require you to pay your loan back within 60 days. If you want that Millennial flexibility to leave a job the moment something better appears, this may not be for you.
- You are taking out pre-tax dollars and putting back in after-tax dollars. When you take that money out in retirement you have to pay tax on it again. No one likes to pay tax twice.
I see a 401(k) loan as a last resort situation. With all the negatives to taking the loan, I would encourage you to look elsewhere for that money. It might not feel good to have to spend all your savings on this need, but it might be the better option in the long run.
While we are on the topic of savings, let’s do a refresher on a cash reserve. A typical cash reserve is 3-6 months of living expenses. This is money you should have on hand for emergencies. This is where I would look to when a need came up. And if you are confident in your budget, you know that a surprise won’t throw you off. I know it is a mental challenge to use up all your savings for an emergency now vs taking from your retirement money that you won’t use for many year. However don’t sacrificing your future security for something that might have been avoidable now.
Be prepared for emergencies and plan ahead
When a need arises, think about where you can get the funds and really weigh the pros and cons. Educate and empower yourself to make the best decision. You can’t go back in time and fix a poor decision made earlier, but you can plan now for future situations. If you have debt, you should lay out a plan. Start by laying out all your goals and then prioritize them. What matters most to you now? Is it paying off student loan debt, saving for a house or retirement savings? Only you can answer those questions. And maybe there are two that are equally important and you focus on those and contribute equally to them so that you can make progress towards both. No matter what, you must prioritize your goals.