Disaster relief: Should you borrow from your 401(k)?

Disaster relief: Should you borrow from your 401(k)?
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Financial rebuilding after a natural disaster can be daunting. Here’s a list of things to consider before you tap into your retirement savings.

The effects of a natural disaster can be felt long after the storm has passed. And, while it’s a sad truth that many things cannot simply be rebuilt or replaced, we must still look to the future—at our own pace. Because we still have futures to enjoy and protect.

Many people ready to rebuild after a devastating natural disaster, like Hurricanes Harvey and Irma, may be eyeing what is likely their largest nest egg: their 401(k). There’s a “break glass in case of emergency” reassurance to having built a healthy 401(k) balance, and there are few greater emergencies than digging out from a natural disaster.

Still, taking from your 401(k) comes with its own set of consequences. So before you break into your retirement piggy bank, consider this:

Explore other sources of relief first

Property insurance or federal disaster loans are built specifically for times of need. The pro is that they’ll deliver the cash you need—without posing a threat to your retirement savings future. But, if the aid takes too long or gets tied up in regulations, it may be tempting to turn to your 401(k) as a stop gap.

Consider a loan rather than a withdrawal

Withdrawing money from your 401(k) is almost certainly a taxable event and may include an early withdrawal penalty for participants under the age of 59 ½. For example, a 40-year-old in need of $35,000 for living expenses, shelter and repairs may need to withdraw closer to $50,000 to offset tax withholding (typically 20%) and a 10% withdrawal penalty. A loan, on the other hand, can be taken out for the exact amount you need. And assuming it is repaid, a loan is not a taxable event.

Understand the true cost of the loan

While a loan eliminates the added cost of taxes and penalties that a withdrawal would bring, it still needs to be paid back with interest. In a sense, that’s a good thing—you are paying interest to your future self for the convenience of borrowing today. But it’s important to understand all the costs beyond the interest rate, including:

  • Any cash you borrow from your 401(k) is taken out of the market, meaning you’d miss out on any potential returns. (To be fair, you may also miss a market downswing, but over the course of a long-term loan, you may be more likely to miss the market’s upside.)
  • Unlike contributions, loan repayments do not help reduce your tax bill—they are made with post-tax dollars.
  • Loan repayments to your 401(k) are also not eligible for company match contributions.
  • These hidden costs are compounded if you are forced to reduce contributions, or give up increasing future contributions, in order to make loan repayments.

Repay the loan as quickly as possible

Again, 401(k) loans exist for a reason. If you decide to take a 401(k) loan to tide you over until insurance or disaster funds are available, be sure to have the discipline to repay the loan as soon as you are able.

Natural disasters exact varied and innumerable tolls—and the road to recovery is often long. With respect to financial rebuilding, we would urge that you not trade a problem today for one tomorrow. While it may seem far-off, the first choice should be to leave retirement savings intact, if at all possible, and opt instead for other sources of relief.

But, if you do need to break the emergency glass, please try to put a solid plan in place—and stick to it—to help preserve your future retirement security. And if you are digging out from under, you are in our thoughts and prayers. Everyone at BlackRock wishes you a speedy recovery.

This article was originally posted on BlackRock Blog

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