The Los Angeles Timesrecently reported that 25 percent of Americans are dipping into their 401(k) retirement accounts to pay bills. So what’s wrong with tapping your 401(k) or 403(b) plan to pay bills? The first problem is it indicates a fundamental breakdown in financial planning.
You should never have bills that you cannot afford to pay. Emergencies happen, though. So have a fallback cash position. Dipping into your retirement savings before you retire is reminiscent of the people who borrowed against their home’s equity during the real estate boom of the early 2000s. Whatever gains they had were being compromised by borrowing. And like home equity, retirement plans fluctuate in value.
The second problem with borrowing from your retirement fund is you’re likely to do it again, according to Bill Herrfeldt who writes for eHow Money. This turns your retirement account into a slush fund. Don’t create a dependency on an asset that fluctuates in value. Discipline yourself to create a separate account for emergencies or extras.
Some people, especially those under 50, argue that whatever loan they take from their retirement account can be made up with extra contributions. The government limits the amount of money a person can contribute to a retirement plan. Plus, when you withdraw money early you pay taxes, penalties and lose the benefit of long-term tax deferral as well as a compounding rate of return.
If it’s best not to take a loan from your retirement plan, then how should you plan for unexpected bills? Keep cash on hand, including an ample amount of money in a checking account. Consider the major expenses you will encounter at certain points in your life. If you’ve bought a new car, for example, determine what maintenance might cost for the next five years. If you’ve purchased a home, what does a new furnace or roof cost? Smart planning means assuming there will always be an "unexpected" expense and putting away cash to meet the need.
If you’re determined to take a withdrawal from a 401(k) or 403(b) plan, then stick to allowable distributions. That means medical expenses, first-time home purchases and certain educational expenses. Several of these are exempt from the 10 percent early distribution penalty. Understand the difference between taking a loan versus a distribution. Remember that these plans were designed to be retirement savings tools. They work best that way, not as glorified savings vehicles. Bankrate.com reported in April 2013 that “low CD rates and rates on other savings vehicles could cause retirees to run out of money before they run out of life.” Especially now, taking money out of your retirement plan and losing the benefits of compounding could cripple your long-term results.
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