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Three Reasons Why You Shouldn’t Cash Out Your 401(k)

Planning for a big purchase can be an exciting time in your life. You may be looking to plan your next family vacation, fund a wedding, buy your first home, or start a family.

Whatever you have in mind, big purchases such as these may have you considering borrowing from your 401(k) or other retirement accounts. While this is an option, tapping into your retirement savings shouldn’t be your first choice.

Here are three reasons why borrowing from your 401(k) and similar retirement plans should be your last resort.

1. It might be more expensive than you realize

You could incur additional taxes and penalties for taking an early withdrawal. When you withdraw money from a retirement account early, you’ll have to pay an additional 10% penalty fee.

Additionally, every dollar you take out will be taxed as earned income at your income level and bracket for the year. For example, if you earn $100,000 and withdraw $100,000 of your pre-tax retirement savings, you’ll be taxed as if you earned $200,000 that year.

When you save for retirement using pre-tax dollars, you are deferring your income taxes on that money until retirement. The purpose is to reduce your tax burden today and realize your income when you are in a lower tax bracket at retirement, when your primary source of income might be Social Security benefits.

2. Borrowed money is no longer working as hard for you

Sure, the cash you take out is helping you with some short-term needs. However, you lose the long-term growth potential that your money could have within your retirement account. Your retirement account is designed to grow over time through compounding interest, potential dividends, and participation in market growth. It would be best to weigh whether you can afford the potential long-term hit to your savings and risk your future financial freedom.

When you take a loan from your workplace retirement plan, your cashflow may suffer as a result. Monthly payments are typically taken out of your paycheck automatically, and not all terms are favorable to borrowers. It’s a good idea to compare bank loans and other alternatives to make sure you understand your options. It’s possible you’ll be better off leaving your funds invested and taking a loan elsewhere.

3. A change in your employment status speeds up the repayment clock

The loan repayment period you agree to is only valid as long as you’re working with your current employer. Once you leave your employer—by choice or by termination—you must repay the loan in full by your tax filing deadline for that year (including extensions).

What happens if you don’t? The IRS will treat that loan as a taxable distribution, hitting you with a tax bill on the outstanding amount, plus a 10 percent early-withdrawal penalty. So, be sure you know where you stand with your current employer before you agree to that loan.

The Bottom Line

Your workplace retirement account is not meant for emergencies or making a big purchase. It’s there for retirement. Borrowing your retirement savings comes with costly strings like a delayed retirement.

While nothing in the future is certain, a well-organized financial plan is the best protection you can have to ensure that your future unfolds the way you want it to. By creating a plan, you are investing in your future self and increasing the likelihood of reaching your long-term goals. Knowing how to prioritize your spending and create a savings plan for your next big adventure will help make those moments more memorable and less stressful.

Want to learn more about saving for retirement? Check out this recent article about why Compounding Interest May Be the Most Important Thing to Learn in Personal Finance.

Investment advice offered through OneDigital Investment Advisors, an SEC-registered investment adviser and wholly owned subsidiary of OneDigital.