People often ask my opinion on retirement plan matters. So here are my thoughts…
Taking a Loan
401(k) loans are very popular. I have no problem with a participant taking a loan from their 401(k) for a major asset purchase and in some dire emergency situations. Obviously if you are in a serious financial situation and you can’t borrow money anywhere else, a loan from your 401(k) is something you need to do. And if you are buying a home, you are purchasing a major asset that will also be a part of your retirement. When you borrow to purchase a home, you are exchanging a portion of one asset (your 401(k)) for another asset (your home).
Regardless the reason, participants must be aware of all the costs of taking a loan from their 401(k).
Fees – loans have set up fees and ongoing fees
Lost investment gain – the money you borrow is taken out of your account and the stock market. When the stock market goes up, the borrowed money doesn’t earn that gain. The loan has a very low interest rate, and you pay that interest rate. This is a significant cost on large loans with longer terms.
Lost savings – if you take a loan you must be careful to avoid the biggest potential cost. Some participants reduce their contribution deduction so they can afford the loan repayment deduction. Reducing your contribution will have a negative impact on your 401(k) account.
Bad habit – taking multiple loans over the years increases all of the above costs. Over time these costs significantly erode your account balance.
Paying Down Debt
I am often asked about paying down debt vs. contributing to the retirement account. People have limited cash flow and want to know how best to put their money to use: should they contribute for retirement or pay down debt?
My answer may sound like a cop out, but both are important and should be addressed.
The mathematical approach to answering the question requires comparing the interest rate you are paying on your debt vs. the investment gain you are earning on your investments. Your money should be directed towards the higher rate.
Paying down debt is important. Some long term debt is necessary, like a mortgage or college loans, but short term credit card debt is not good. You should always strive to keep your short term debt minimal. Please, if you are having trouble in this area, seek the help of a credit specialist who can help you manage your short term debt.
Investing for retirement is extremely important. People are living longer and longer and the cost of living is going up, especially the cost of healthcare. Social Security doesn’t provide a meaningful retirement income now and it is not going to be around forever. If you don’t invest for your own retirement, the outlook will not be good.
Actually paying down debt and investing for retirement go hand in hand, because short term debt hampers your ability to invest and will definitely reduce your standard of living in retirement.