Personal Finance: Borrowing from 401(k) to pay debt is risky move
Answer: You have saved a good amount for retirement, but without knowing your income, it's not clear if it's enough.
Financial planners tend to want people to have at least enough savings when they retire to provide annual income that's 70 to 80 percent of their pay in the last year they were working. When you are close to retiring, you can quickly look at whether you've saved enough by multiplying your salary by 12. If your savings match that, you are in the ballpark.
At age 40, you can test to see if you are on your way. By that age, you need to have built up 2.4 times your existing annual pay to get to the 80 percent threshold eventually. So if you are making $100,000, that would be a sum of $240,000 in the 401(k).
Still, even if you are close to being on target with your saving, I am reluctant to suggest borrowing from your 401(k) to pay off credit card debt.
You are likely to save yourself some substantial interest charges if you do wipe out your card debt with a 401(k) loan. Paying about 4.5 percent interest to repay a 401(k) loan makes a lot more sense than paying 12 percent on credit cards. And when you pay interest on the 401(k) loan, the money goes back into your savings, not to a bank.
But often when people wipe out their credit card debt with an alternative loan, they don't take the steps to build a more carefree future by setting up a budget, looking for cuts in expenses, or finding an extra job. Before they know it, they are stuck with a lot of debt again.
Research by TIAA-CREF of people who have borrowed from 401(k) plans shows that 43 percent borrow a second time. So, clearly, the first loan didn't give them the fresh start they imagined.
And when they borrow from their 401(k), they undermine their future ability to build the retirement money easily.
Why? The larger the sum of your early savings, the more interest or return you make for the future, even if you add modest amounts as you near retirement. So a nice sum in your 401(k) at 40 means you are making your future less stressful. Consider the impact of time on tiny early life savings: A person who puts $25 a week into a 401(k) starting at 21, invests it in a balanced mutual fund of stocks and bonds, and leaves it there, is likely to have close to $1 million by retirement. A person who would like the same nest egg, but waits until age 45 to start saving, would have to save about $300 a week. Painful!
Now consider a 401(k) loan impact: Let's say you decide to borrow $20,000.
If you try the "Should I borrow from my 401(k)" calculator (bankrate.com/calculators/retirement/borrow-from-401k-calculator.aspx) you will see that you will end up at retirement with about $20,000 less than you would if you hadn't touched the money. I assumed that your 401(k) stock and bond mutual funds earn about 8 percent a year, on average, and that you'd repay your 401(k) loan over the typical five years at an interest rate of 4.5 percent.
If you end up failing to repay the $20,000 you borrowed, you will have $399,000 less at retirement than if you'd left your money in the 401(k).
Now, you probably have every intention of repaying your loan as required over five years. But if you fail to repay it, the federal government will make you pay taxes and a 10 percent penalty on the money you withdraw from the 401(k).
About 86 percent of people who lose their jobs end up failing to pay back their 401(k) loan and suffer the penalties, according to research by the Pension Research Council at the University of Pennsylvania.