To some people, 401(k) accounts look like giant piggy banks. Although you know that money is supposed to remain untouched until retirement, it's tempting to tap those funds when you're in a pinch. In fact, over 25% of households with 401(k) plans have withdrawn money from their accounts to pay for needs other than retirement, according to research from HelloWallet.
Withdrawing money from your 401(k) before you reach age 59 1/2 can have serious financial consequences, both immediately and in the long term. Compound interest allows your contributions to grow faster over time, which means the longer your money is left in your account untouched, the more it will grow. So when you withdraw money from your 401(k), in the long term, it will cost you far more than the amount you took out.
Continue Reading Below
However, if you truly need to take money from your 401(k), choosing to borrow it, rather than withdraw it, can help your savings get back on track.
Borrowing vs. withdrawing: What's the difference?
401(k) loans and early withdrawals both involve taking money from your 401(k), but the similarities end there.
When you take out a 401(k) loan, you have to pay interest on that loan (which is typically the prime rate plus one percentage point, so usually around 4%–6%), and in most cases you must pay it back within five years. However, your payments and interest are deposited back into your account, so you're essentially paying yourself. Because your loan is tied to your employer, if you leave your job, you will likely be required to pay back the loan within 90 days or risk paying income taxes and a penalty.
Withdrawing from your 401(k) is different in that you don't need to pay back the money, but you will normally need to pay a 10% penalty as well as income taxes on the withdrawn amount if you withdraw before age 59 1/2. At first glance, this may seem like an attractive option: You're not required to repay your withdrawal, there are no interest payments, and you can take your time getting back on track with your savings.
But those reasons are why borrowing is actually the better option. When you borrow, you're forced to rebuild your 401(k) through loan repayments and interest. With withdrawals, you're on your own when it comes to making up for lost ground -- which can make it far more difficult to get back into the habit of saving.
In addition, the income taxes and 10% penalty can take a significant bite out of your savings. Say, for instance, you're under the age of 59 1/2, you're earning $50,000 per year, and you choose to withdraw $10,000 from your 401(k). You'd have to pay $1,000 right off the bat as a penalty, then you'd end up paying an additional $2,500 in income taxes (assuming you're filing as single with no dependents).
The long-term effects of loans and withdrawals
While the penalty and additional taxes involved with withdrawals may sting, the long-term effects are even more harmful to your financial future.
Let's look at two different scenarios. In scenario one, you borrow $5,000 from your 401(k) and pay it back over five years at 5% annual interest. In scenario two, you withdraw $5,000 and pay a 10% penalty as well as income taxes. Also, because you're not forced to repay a withdrawal as you're forced to repay a loan, let's also assume you don't make any additional contributions over the next five years.
In scenario one, you'll repay your $5,000 loan plus an additional $661.37 in interest over five years -- all of which goes back into your account. Because some 401(k) plans don't allow you to make additional contributions as you're repaying your loan, you're also missing out on potential gains -- which has both short- and long-term effects.
Let's say you had $50,000 in your 401(k) before the loan, and if you hadn't taken the loan, you would have been contributing $100 per month (which you continue contributing after you've repaid the loan). Here's what your total savings would look like over five, 15, and 30 years depending on whether you borrowed from your 401(k):
Also keep in mind that these results don't take employer matching contributions into account. If your employer matches contributions, you could be missing out on more by not making any additional contributions.
As dramatic as these results are, you may stand to lose even more if you withdraw that $5,000, rather than borrow it. In scenario two, you'll owe $500 in penalties, and if you're earning $50,000 per year, you'll end up paying an additional $1,250 in income taxes. So, out of the $5,000 you're withdrawing, you'll actually see only about $3,250 of it.
You also aren't required to pay back what you withdraw, so let's say you go five years without making any contributions and then start contributing $100 per month. Here's what your savings would look like over time:
Keep in mind, though, that this assumes you'll be back on track after five years. If it takes you longer than anticipated to get saving again, or if you slow down your savings and contribute less per month, that will have an even greater impact on your total savings.
Repayment deadlines and interest payments may seem like downsides to borrowing from your 401(k), but they make it easier to keep your savings on track. You can also avoid paying thousands of dollars in penalties and taxes, and when you're required to pay back the loan within five years, it helps ensure that you're not taking more than you need from your 401(k).
While the best-case scenario is to leave your 401(k) funds untouched until retirement, that's not always possible. If you need to take money from your savings, it's typically wiser to borrow -- not withdraw.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.