Caleb Bagwell, Education Specialist for Grinkmeyer Leonard Financial, does a wonderful employee education presentation where he compares accounts used for keeping money as cookie jars. For example, your checking account is a blue jar, your savings account is a yellow jar, and your 401(k) account is a green jar. From there he goes on to explain that the investments within those jars are the cookies; sugar cookies are a money market, chocolate chip domestic equity, white chocolate macadamia are internal equities, and so on. (For more Calebism’s check out his blog ) . So what happens when your blue checking account is running low and you need some more cookies ? A significant number of people turn to their green 401(k) jar because, after all, it is your money to begin with. Although, this may seem like a quick and easy fix, it can have long term negative effects on your ability to retire.
Should You Really Be Reaching Into the Jar?
T. Rowe Price recently conducted its eighth annual Parents, Kids, & Money survey and found that 44% of parents said that in the past two years they had used money saved for retirement for a non-emergency expense. Around 17% used the money to pay off debt which could be a semi-sound financial move depending on the interest rate of the debt paid off, but an equal amount, around 17%, said they had used the money to pay for vacation and 16% used the money for their children’s education. Let’s start with vacation. While I am an advocate for work-life balance and think that a well-deserved week away from the office does an employee good, a vacation falls into the category of “if you can’t pay for it, you shouldn’t do it”, especially if it means dipping into your retirement savings. Using your retirement savings to fund a child’s education can also be an inappropriate use of your money. While loan, particularly student loan, has become a four letter word, the truth is that your children have a much longer time span to pay off a student loan, then you have to save for retirement.
But They Are My Cookies to Begin With!
One of the most common arguments I hear as a reason to take loan from your 401(k) account is that is it you are paying yourself back rather than a financial institution. However, there are several reasons why this argument leads to a slippery slope. The first, and main reason, is you are paying yourself back with after-tax money and that money will be taxed again when you take it out in retirement as a distribution from your 401(k) account! To explain, If you are in the 25% tax bracket, earning $1 only gives you $0.75 toward repaying the loan, and that $0.75 will be taxed again when you retire and withdraw if from your plan. The second factor to consider is opportunity cost. Opportunity cost is the alternative that is given up when a choice is made; in regards to your 401(k) that cost is the potential market gain that you are missing out on while your money is out of the plan. A third reason to consider about taking out a 401(k) loan is that you have potentially handcuffed yourself to your current employer. The full balance of a loan becomes due when you terminate employment and if you cannot repay the total amount, then whatever you cannot pay back becomes a taxable distribution that is also subject to a 10% penalty if you are under age 59 1/2. First consider the fact that the term for most 401(k) loans is 5 years. Then consider that according to a 2015 study conducted by the Bureau of Labor Statistics that of the jobs that workers began when they were 18 to 24 years of age, 69% of those jobs ended in less than a year and 93% ended in fewer than 5 years and among jobs started by 40 to 48 year olds, 32% ended in less than a year and 69% ended in fewer than 5 years. Consider those 2 facts together and it is reasonable to think that the majority of employees who take out a 401(k) loan will not be at their employer long enough to be pay it back in full.
Just Say No
While the idea of dipping into your retirement savings to take care of a today need may be as tempting as biting into a warm chocolate chip cookie, in most cases it is best to just say no! Once you say no once to compromising your retirement savings, it will get easier and from there you can start to address the underlying reason why you probably needed the loan in the first place, the lack of sufficient savings. The T Rowe survey mentioned earlier also found that 72% of parents don’t have enough savings to cover at least 3 months of living expenses and 49% said they didn’t have an emergency account at all. We have some great resources that speak to the importance of budgeting and would be happy to help your employees start the process of setting and following a budget.
Cookies and 401(k) loans are tempting because they are usually easily accessible and have a certain level of immediate gratification. Let us at Grinkmeyer Leonard Financial help you find a better way to tame the temptation.
Jamie Kertis, AIF®, QKA
Retirement Plan Specialist
Grinkmeyer Leonard Financial
1950 Stonegate Drive / Suite 275 /Birmingham, AL 35242
Office: 205.970.9088 / Toll-Free: 866.695.5162