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401(K) Early Withdrawals And Loans: Why They're A Really Bad Idea

401(k) early withdrawals and loans: Why they're a really bad idea

Here's a disturbing trend: Since the financial crisis, more and more Americans have been tapping their 401(k) plans for loans or taking early withdrawals.

Raiding retirement accounts is almost always a really bad idea. Investors need to think of their 401(k) retirement plans as long-term funds that are off-limits to current spending requirements. Investors need to let time and compound interest work their magic.

Aside from lost potential returns, breaking open your 401(k) piggybank can also trigger penalties and taxes.

According to industry research, the median size of a 401(k) is $24,400 as of March 31 2014, with people older than 55 having $65,300. IRS data on early retirement account withdrawals show a sizable number of Americans are hitting up their nest eggs to underwrite their lifestyles much as consumers did with home equity loans during the early 2000 housing boom.

If you take a distribution from a traditional individual retirement account such as a 401(k) or other qualified retirement plan before you turn age 59½, you pay 10% penalty tax. The proceeds are also added to your taxable income. That's why early withdrawals should be avoided in all but the most extreme cases of financial hardship.

Taking loans from your 401(k) isn't a great idea either, in most cases, say the money pros.

Most 401(k) plans will let you borrow up to $50,000 of your vested balance, and the loan typically must be paid in five years. The interest rate is usually a couple of percentage points above the prime rate. However, if you leave your job (and you are younger than 59½) you will get smacked with a 10% penalty tax on the remaining balance, plus ordinary income taxes, notes Rodney Brooks at USA Today.

Financial advisers generally frown on 401(k) loans unless an individual is really up against the wall and has no other recourse. As financial planner Bob Mecca, president of Robert A. Mecca Associates in Prospect, Ill, notes:

"Many people don't have enough saved for retirement in the first place, and when they take their 401(k) out of the equation and borrow the money - typically up to 50% of their balance - then that money is no longer working for their retirement needs. And the money is no longer growing, compounded and tax-deferred."

There are two other related issues with 401(k) loans, according to this useful post by Investopedia. While you may get a reasonable interest rate on your retirement fund loans, it is more than offset by the lost market appreciation you are forgoing by not have those dollars growing on a tax deferred basis. In addition, you are paying yourself back with after-tax dollars.

Consider this example from Investopedia:

"If you are in the 25% tax bracket, earning $1 only gives you $0.75 toward repaying the loan, and that $0.75 will be taxed again when you retire and withdraw if from your plan. While the interest rate on the loan may be low, you are getting taken to the cleaners by its tax implications."

Perhaps the biggest reason not to borrow from your future is that it is a pretty good signal that your personal finances need a salvage job and you're living beyond your means. Take a timeout and work to get your spending in line before raiding the piggy bank.

Photo credit: _e.t via Flickr Creative Commons

DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk, the amount of which may vary significantly. Past performance is no guarantee of future results.

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