Will your child be better off than you are?

A recent article in Money Magazine provided some interesting statistics.  A group of people was asked how they felt the economy would impact their lives.  From questions about children to retirement and family life, the results were interesting to read.

53% of Americans aren’t sure their kids will be better off than they are.

How many of you have said or heard this before?  It’s a noble thought to want those you love to have a more successful life than you lived.  But half of those surveyed didn’t feel like their children would have it better than they did.

While there are circumstances that we cannot control (i.e. available jobs and investment performance) we can do some things to make sure the next generation is truly better off than we are.  Here are two ways that I thought of:

• Instill an attitude of contentment – I really liked the article that Joe wrote over at Christian PF entitled: How to Raise Non-Materialistic Children.  What better way to set them up for success than to prepare them to be content with what they have in life?  I think we can all agree that a lot of the economic trouble we’re in today was caused by greed and discontentment, so encouraging children to be content with the things they have will put them way ahead of the crowd today.
• Encourage financial education among children – This follows closely to point one.  If you don’t emphasize the importance of a budget and saving when your children are young, they might not catch on until it’s too late.

67% worry their quality of life will suffer in retirement.

Unfortunately, a lot of Americans have held onto a false sense of security when it comes to Social Security.  I think the fear of the unknown has driven many soon-to-be-retirees to the point of worrying.  So how do you combat those worries?  If you can afford it, you can try to max out retirement plans.  You can also take some larger measures and downsize your home.  I know my parents are looking to downsize and it will save them a tremendous amount of money in their retirement years.

80% say they’re eating at home more often.

I definitely fall in this category.  We like to cook at home anyway, but the eating out budget is the first to go when finances get tight.  We still find creative ways to treat ourselves, but we usually end up eating around the table almost every night of the week.

75% say that time with the family is more important than ever.

The wording on this is interesting to me.  It’s not that 75% of people think their families are more important than they were five years ago.  Most would say that their family has always been a priority in their lives.  To me it says that people are realizing which priorities truly matter most.  We’re not guaranteed another day with our family members and we can’t replace them like we can a job or house.  If there is one good thing that has come out of this economic dip, I think we can consider this one a positive thing.

So what about you?  Do you agree with these stats?  Would you fall in the majority or minority for the topics that were mentioned above?

Tim is a personal finance writer at Faith and Finance a Christian financial help blog that provides financial insights for individuals, businesses, and churches. Outside of finance, Tim enjoys spending time with his wife, playing the saxophone, reading economics books, and a good game of RISK or Catan. Find him on Twitter and Facebook and subscribe to the Faith and Finance RSS feed.

It's NOT too late.

My friend Alex, at age 56, has made very little plans for his retirement.  He also believes that he is too old to start.  In a recent conversation with him, I learned:

• He has very little (if any) retirement investments and is not currently saving any appreciable amount.

• He will still be making house payments he is 71 years old.

• He has recently purchased a vehicle that he will be paying on for several years.

• His currently works two to three jobs requiring physical activity.

• He is in decent health, but has had increasing knee and leg pain in recent years.

• He is the sole provider for his family.

I could feel my stress level increasing as our conversation continued, but Alex seems to believe that somehow his retirement will magically be OK.   “After all”, he says, “we have always managed to get by so far…so we will make it fine when retirement age comes.  Besides, I am too old to create a retirement plan now, so what is the point in trying?”

Because Alex thinks he has waited too long, he has blocked the very aspect of making any retirement plans from his mind.  Alex is wrong.  It isn’t too late.  If you, like Alex, have given up on trying, you are also wrong.  No matter what your age, there are positive steps you can take today to make your retirement a plan instead of a fuzzy wish.  This tips will help:

Make a plan.

Be realistic. If you cannot achieve a retirement income equal or more than your current working income, plan for your retirement standard of living to be lower than your current standard of living. And DO NOT count on Social Security to fund your retirement. It is a broken system doomed for failure.

Get out of debt.

I know. You hear this all of the time. But this one step is the simplest way to increase your retirement cash flow. Think of it like this: that $500 car payment, $800 credit card payment and $400 furniture payment translate to $1,700 a month toward your retirement income – IF you pay them off. This equates to drawing 3% annually from a $680,000 nest egg. Which is easier: getting out of debt or saving $680,000?

Pay off your house.

House debt and retirement are not good chemistry. As in the previous illustration, that house payment will be going to you instead of the bank – when the house is paid for.

Hint: if you are considering purchasing a house, plan the term of the loan to be less than the number of years before you retire.

Save.

No matter how old you are, it is never too late to start saving.  Start an IRA and max out your IRA contribution limits.  Whatever nest egg you accumulate will be more than if you don’t start. Besides, you will be learning a habit that you will need once retired: live on less than you make.

Plan to work part time.

What do you love to do? Start doing it part time now and save every penny you earn. Then, when you retire from your full time job, you can supplement your retirement income by doing something you love to do.

Keep working as long as you can.

Retirement does not magically happen at some arbitrary age; it happens when you can afford it. The longer you are able to work (and do the things I listed above), the better you will be able to afford it.

Don’t give up like my friend Alex.  Those years will come whether you prepare or not, so take steps now to prepare.

Alex: are you reading? I hope so.

Readers: what other suggestions do you have for those who have not planned for retirement? Any ideas on how to make the Alex’s in this world wake up?

Picture Dave, a 52 year old father of three who plans on working until he can no longer stand to work.  He really hasn’t saved much for retirement and has a mortgage payment of $1,200 with $50,000 left on the mortgage.  He and his wife have approximately $40,000 in savings and investments and he is considering using his savings to drastically reduce his mortgage and pay it off in the next few years.

Is this a wise move?

Obviously, we can’t see the entire picture from the 100 word paragraph above, but there are a few things that should not be looked over if you were in Dave’s shoes.  I’ll make note of a few and welcome suggestions in the comments as you think of them.

While it would be nice to have ALL debt paid for (especially as you near retirement) it’s important that you don’t forget about the other aspects of your financial picture.

Don’t use up your emergency fund.

For a working couple, most financial experts would suggest a 6-12 month emergency fund.  If I were in Dave’s situation, I would want to be on the higher end of that statistic with respect to an emergency fund.  This doesn’t leave much room in his $40,000 of savings to apply towards the house.

What’s your income situation look like?

Do you anticipate a drop in your income within the next few years?  How about an unexpected drop in your income from an unexpected layoff?  If you put your entire savings (or a good chunk of it) into your home, you won’t have access to it without taking a line of credit, or selling your home.  In this market, both may be difficult tasks to complete quickly.

What about your expenses?

Dave’s no spring chicken and with retirement around the corner, so are the potentially higher medical bills.  A recent report from Fidelity showed that a 65 year old couple retiring this year will need $250,000 to cover medical costs throughout their retirement years.

And don’t forget the kiddos.  They’re about to head out to college and may need some help getting their feet on the ground.  Of course, they can borrow for school – Dave can’t borrow for retirement.

Will you stay there for good?

Before Dave dumps all his money into a home for the sake of being ‘debt free’ or eliminating an annoying house payment, he needs to honestly ask the question: Do we plan on moving in the next 5 years?  If downsizing is in the immediate future, there isn’t really a good reason to tie up all that money into a home with the hopes that you’ll get it back after selling it.

At the end of the day, cash is king and if you can find other ways to reduce debt while maintaining a strong cash position, I’d consider that first.

So what would you do if you were Dave?   Put money towards the home and ditch the payment, or float the payment while you maintain your cash reserve and continue to save for retirement?

Meet you in the comments!

Tim is a personal finance writer at Faith and Finance a Christian financial help blog that provides financial insights for individuals, businesses, and churches. Outside of finance, Tim enjoys spending time with his wife, playing the saxophone, reading economics books, and a good game of RISK or Catan. Find him on Twitter and Facebook and subscribe to the Faith and Finance RSS feed.

Read about these three toward the end of this post

The traditional view of retirement — working for the same company your entire career and then retiring to draw a lifetime pension — is a thing of the past. Yes, some government workers continue to retire with paid pension plans, but as states and municipalities continue to fight for survival, these pension plans will also be phased out. To add to the angst, Social Security is scheduled to run out of money within the next 25 years.

The bottom line is that many, many of our upcoming retirees are in trouble. The average baby boomer has less than $100,000 set aside for retirement and, according to Financial Planning magazine, 56% of those nearing retirement age have no idea how much income they will have in their retirement years.  Because they have no personal finance plan, the time to wake up is now.

“But Joe”, you stammer. “It is too late for me to do anything now. I have waited too long.”

“Wrong! You just need to redefine your retirement. These tips will help.”

1) Learn where you stand.

Whether you run the numbers yourself or get some help from a financial counselor, you need to know the truth. Answer these questions: “If nothing changes, what will my retirement income be?” and “How does this compare to my current standard of living?”

2) Budget accordingly.

Based on what you learned, make the appropriate changes now.  Make those sacrifices today, while you have a choice, because some day you won’t have that choice.

3) Pay off your house.

Think of it this way: getting that house paid off will bump your retirement cash flow by whatever payment you are currently making. Besides, having your home paid for in your retirement years will give you a security you wouldn’t have otherwise.

4) Invest in your health.

No matter how fit you are financially, your retirement will be dampened if you lose your health. Our local community college offers exercise curriculums, with all of the equipment and a trainer for only $30 a semester. The time to invest in your health, regardless of your age, is now.

5) Don’t retire.

One way to redefine your retirement is to change that definition from one of lazing around for the last 20 or 30 years of your life to one of staying active and productive. Ask yourself, “What dreams have I left undone?” If you do what you love to do, you won’t want to quit doing it…ever! Fulfill that passion and your later years will be full of wonder and meaning.

To close this post, I challenge you to allow some of these seniors inspire you to redefine your retirement:

• Olive Riley: began blogging at age 107, and continued until two weeks before her death at age 108.

• Pierre Jean “Buster” Martin: Claims to be the United Kingdom’s oldest employee at the age of 102, and notably refused to take a day off on the day he celebrated his 100th birthday. Martin entered the 2008 London Marathon and, according to press reports, he walked the 26 mile course in approximately 10 hours.

• Arthur Winston was a Los Angeles Metro employee for 72 years. He is best known for being honored as the “Employee of the Century” because he was never late to work and only took one day off during his entire career.

• Ron Donahue (72), Norm Benson (77) and George Nesbitt (80), who volunteer their carpenter skills to make school desks for special needs children.  (See picture at beginning of post).

Maybe you won’t run a marathon or work for one company 72 years, but you CAN live life to the fullest for all of your life.

Doing so will redefine your retirement.

Readers: In what ways do you need to redefine your retirement?  What changes do you need to be making today?

I recently received a delightful letter from a college student who wanted my advice about investing for retirement. I say delightful because I simply don’t know many college aged young adults who have retirement anywhere on their radars.

In formulating my response, I made a couple of assumptions:

1. He either has debt (college or car) or needs his income to avoid such debt.
2. He does not have an emergency fund in place.

Read on for his letter and  my response.

Letter from Chris

Hi,

My name is Chris _____________. I am getting in touch because I have read a couple of your articles and I thought it would be a good idea to see if you would be able to offer me any financial advice. I am currently 21 and will be entering my fourth year in college. However I transferred into the program that I am in so I still have about two more years to complete. I have been talking with my mother about what I can be doing now to start saving money for retirement. I recently had the opportunity to invest in a 401k with my work, however it is only a part time job and I don’t know how much longer I will be here. I was also thinking about investing in an IRA. It is difficult because I don’t know what I want to do after I graduate or where I want to be geographically. If possible I would greatly appreciate it if you could give me any information or help. Thank You.

My Reply

Dear Chris,
I am very excited to hear from a college student who is thinking about how to invest for retirement. You are a rarity in today’s world! You may be surprised at my answer, but I would rather see you save your money right now instead of investing for retirement. The reason is simple: you will probably need the money, and if you have it tied up in retirement investments, you may be forced to borrow money for such things as:

· Making it through college.
· Buying or repairing a car.
· Paying for a place to live while you are looking for work after college.

Avoiding debt and paying cash as you go is a lifetime habit that will serve you well for years to come. It wouldn’t make sense today to be borrowing money while investing for retirement…sort of like taking out a loan so you can invest…not smart.

Once you finish college and get situated, I recommend paying off any outstanding debt and building up a good emergency fund before investing for retirement. You will be more relaxed, and, with no debt, you will have a lot more money to invest at that time.

Once you start investing for retirement, I like taking advantage of your 401k up to the point your employer matches. If he matches 3%, for example, I would invest 3% in order to get that “free money”. Investments above that 3% should be in Roth IRAs. You will have to pay your taxes on those investments now, but all growth in the Roth IRA is tax free. That is a good thing when you get ready to retire! Your goal should be to invest 15% of your income for retirement. If you do that, you will be fine.

If you want some good reading, you can go to my blog and read my posts on Dave Ramsey’s 7 Baby Steps. They will explain in more detail exactly when and why you do what you should with your finances. There are 7 articles in the series; the first is Dave Ramsey’s Baby Step 1: Baby Emergency Fund and there is a link at the end of each to the next in the series.

You may also want to read Dave Ramsey’s book, “The Total Money Makeover”. It is the best selling book on personal finance on the market, and a great read. In fact, I would be glad to give you a copy if you promise to read it. Just let me know.

Again, I am very impressed to hear from you. Please write back with any Roth IRA questions — or any other questions you have about my response…and about getting a free copy of The Total Money Makeover.

If you keep asking these great questions, you are going to do well in life.

Joe Plemon

Like I said, this was a delightful letter. It made my day and once again affirmed that at least some of our current generation is thinking about the future.   I wish I could be around when Chris is ready to retire…my guess is that he will be well prepared.

Readers: What did you think of my advice? What would you have said differently? How old were you when you first started thinking about your own retirement?

Most retirees ponder this question: “When should I start taking my Social Security benefits … at age 62? At full retirement age? Somewhere in between?” The conventional response to this question is “Wait as long as you can.” After all, those whose full retirement age is 66 will face a 25% lifetime reduction by starting at 62. They also have the option of an 8% annual boost for every year they delay benefits, up to age 70. In short, the longer you delay, the greater your benefit for the rest of your life.

However, there are times when a beneficiary should consider tapping that benefit early. Here are four:

1. Poor Health

The break even age — the age when the cumulative benefits of starting early equal the total of the higher benefits one would receive by waiting until full retirement age, is around 78. This means that if you live past 78, you are better served by waiting, but if you don’t live to age 78, you would receive a greater total by starting early. Therefore, if your health indicates that you will not live to age 78, you should consider starting your benefits early. Part of that decision, for married couples, should be the impact on the survivor’s benefit, which is generally 100% of the higher-earning spouse’s benefit.

2. Short on cash

If you simply don’t have enough cash flow to make ends meet, it may be better to start receiving your benefit early than to create debt that will haunt you in coming years. However, if you are continuing to work instead of taking an early retirement,  you need to factor in the earnings limit: you forfeit $1 for every $2 earned over $14,160. It generally wouldn’t make sense to begin your benefit early if you will be giving up a chunk of it.

3. You are Single

Maximizing the survivor benefit, (the primary reason many married couples should wait before starting their Social Security) is a non issue for Singles. Therefore, if other factors lean toward starting early, the single person has more reason to do so.

4. You are a lower-earning spouse

If your lifetime earnings are substantially lower than your spouse’s earnings, you should consider starting your pension early while your spouse waits. The logic is to bring some income into the family now, but allow the higher income benefit, which would also be a survivor benefit, to grow. If the higher income is needed as a survivor benefit, you have wisely grown it. If not, that higher benefit will be appreciated by both spouses for years to come.

Many start their Social Security early for the flimsiest of reasons (their neighbor or co-worker or sister said they should). Reality is that there is no “one size fits all” choice. Personal finance is extremely personal, so whatever decision you make about starting your benefit, be sure you clearly understand your Social Security strategy.

Readers: What is your strategy for starting your Social Security? If you are already drawing your SS benefit, did you start before full retirement age or did you wait? Why?

Great retirement will require some ingenuity

For many Americans, the prospect of a dream retirement is fading.  However, those very factors which produce so much gloom can actually make retirement better.  Hold that thought as we first examine the bad news about retirement.

Retirement Pensions are Gone Forever

The days are gone forever when an employee worked for the same company his entire career and retired with a lifetime pension. Industry can no longer afford such extravagances and even government workers are giving up pension benefits as state and local governments nationwide are struggling with huge budget deficits.

The 401(k) is “iffy”

I am a huge proponent of the 401(k) because it forces us take responsibility for our futures. However, with a struggling economy, many companies have cut back or eliminated their match. Without the match, employees are less prone to contribute, thus amplifying retirement shortfalls.

The future of the market is shaky.

Whichever retirement vehicle one uses, if it is dependent on positive stock market returns, the fragility of the market gives little assurance that an investor can depend on having achieved his desired nest egg by his projected retirement date – or hang on to it once retired.

Social security is under funded.

For the first time in 30 years, Social Security will pay more than it takes in this year. Those who run Social Security predict the program will go into the red permanently by 2015 and will run out of money in 2037 unless dramatic changes are made.

How could all of this possibly be good?

Good question. Let’s start by rethinking retirement. Realistically, a life of leisure may not happen for you. But this is not bad. This study indicates that when people retire with little to do, their life expectancy plummets. Why? Evidently work gives people purpose, and people without purpose don’t live as long.

Living your purpose is good.

Reality is that you may need to continue earning an income at a more advanced age than you had previously thought. Therefore, instead of viewing work as drudgery, now is the time to dovetail work and purpose. After all, if you are going to be doing it anyway, why not be doing something that you are gifted at, something that you love, something that meets a need in others’ lives and something that gives you purpose. Your life will have a new vitality and you will not only live longer; you will live better.

Developing ingenuity is good.

With your retirement future hazy, you should develop as many income streams as you know how. This doesn’t mean working 100 hours a week, but it does mean becoming more innovative.   When you allow your creativity to kick in, you will discover both active and passive income ideas — many of which you will be passionate about and will therefore will want to continue later in life. Yes, you need ingenuity, but that is a good thing.

Serving others is good.

“What?” you say, “You challenge me to find my purpose and develop my ingenuity. Now you say I need to be serving others. This is overwhelming!”

My response is that your purpose will include serving others. You weren’t put here on earth to live for yourself. A truly prosperous life is one focused on others, not yourself.

Concluding thoughts

Realistically, your retirement might not come exactly as you schedule it. However, this is not all bad. If you make plans now to find your purpose, become ingenious about your income streams and make serving others a high priority, you will live a rich and fulfilling life.

Allow this quote from James Michener settle deep within:

“The master of the art of living makes little distinction between his work and his play, his labor and his leisure, his mind and his body, his information and his recreation, his love and his religion. He hardly knows which is which. He simply pursues his vision of excellence at whatever he does, leaving to others to decide whether he is working or playing. To him he is always doing both.”

Thanks: My 91 year old Mom, who continued in the work force well into her 70′s, is the inspiration not only for this post, but for me personally.  Thanks Mom!

Readers:  Does the gloomy retirement outlook throw you into a funk or motivate you to be more innovative?  In what ways?

Note: This is a modified version of a previous post I wrote for Christian PF

A reader recently wrote the following comment on my post 4 Reasons You Should Not Use Your 401k to Pay Off Your Credit Card so I have pasted both the comment and my answer, hoping that you readers will help scrutinize my logic and point out any flaws you may notice.  Obviously, I made some assumptions (which didn’t seem unrealistic), but I saw no other way to run these numbers without doing so.

Question from reader

Ok, so what if I don’t want to take out a loan on my 401K? I already practice the snowball effect and we give the minimum amount to our 401k – essentially whatever is being matched by our jobs. We have about $66,000 in revolving CC debt. We could use our 401K to eliminate that debt and be left essentially with only our mortgage payments and my school loan. With all this debt eliminated we could max out our 401k’s going forward at 15% each (we only give 5% now). It would also help come tax time as our taxable income would be lowered considerably if we give the 15%. We would also be able to give additional money to the IRA allowing our 401K to grow at a much more aggressive rate while being virtually debt free. I also realize if we take that much out we will likely be penalized at about $30,000 for this year. My question is, couldn’t this all be offset in some twisted way to work in our favor while getting virtually debt free? I don’t want to borrow, I just want to drain it and use it pay off the debt altogether. The CC debt was created due to losing my job and being out of work for an extended period. We are followers of Dave Ramsey and have been chopping away slowly but would love to start really charging after our retirement but at 5% per person it’s not really getting where we need it as quickly as we’d like. I just feel like if we can get rid of all our revolving debt we could begin really growing our 401K at break neck speed. Thoughts?
joeplemon May 4, 2011 at 10:36 am [edit]

My response

Let’s run some numbers based on the following assumptions:
1. You would need to withdraw $100,000 from your 401k to pay off the $66k in credit card debt.
2. You are 30 years from retirement.
3. Your combined annual income is $50,000, which means you are contributing $2500 annually (5%) to your 401k plans and receiving a 100% match for those contributions, effectively giving you $5000 annual contributions.
4. Over that 30 year period, your investments will earn an 8% average annual return.

Based on these assumptions,

If you continue what you are doing, your retirement nest egg will be about $1.7 million in 30 years. However, if you draw out the $100,000 and start anew with 15% investments (earning 100% match on your first 5% and zero match on the next 10% contribution), you would be effectively investing $10,000 annually. With an 8% return, your nest egg would be worth $1.2 million in 30 years, meaning that withdrawing $100K today is a $500,000 mistake.

It is actually more than that because you WILL eventually get that credit card debt paid off and bump up your investment contributions, thus increasing that $1.7 million you would have if you only contribute the 5% for the next 30 years. For example, if you paid off the credit card debt in five years and bumped your retirement investments to 15% at that time, (although I would recommend a big emergency fund before increasing your investments) your nest egg in 30 years would be about $2.1 million…$900,000 more than if you pulled the $100,000 from your 401k today.

I realize that the money in that 401k is tempting, but I urge you to leave it alone. One of you might consider a second job just long enough to pay off that credit card debt but even if you don’t get it paid down for a long time, your retirement will be more solvent by leaving your contributions in the fund instead of tapping what you have worked so hard to build up.

I also realize that I made some huge assumptions, but the results would be very similar even if the specifics changed considerably.

Please write back. Feel free to ask questions and let me know if what I have said makes sense.

OK readers — your turn. What advice would you offer? In what ways do you agree with me? How do you disagree?

Readers sometimes ask for my advice, as in today’s post.  Although the advice I give might be worth what they paid for it, I strive to do my best.   Following is a copy of an actual email (without names), along with my response.  I would love to hear your thoughts on whether this family should sell their house to pay off their debt.

Letter from reader:

“Hi Joe, thank you for taking our question! Although I know we have been poor money managers we are now in our early 50’s, have 3 kids in college that are 100% loan funded, and about $40,000 in debt other than education. We have about $50,000 equity in our home. We are contemplating selling our home, paying off debt and renting an apartment for a couple years to get ahead.
We have approx. $1,000,000 in retirement, but are living paycheck to paycheck along with trying to keep our house updated and repaired in case we need to sell.
What is your opinion?
Thanks again for your time if you ever really see this e-mail yourself!

My response:

“I don’t think selling your home is a good idea because you would be circumventing your real problem: in your own words “poor money management”. Yes, you could do so and use that $50,000 to pay off debt, but unless you learn to manage your money, you would still be living paycheck to paycheck. I want to congratulate you on your retirement nest egg. Well done! But giving up that home equity could endanger that retirement. How? Because you should be planning to have a paid for house when you retire. Being at the mercy of a landlord or having huge house debt (assuming you buy another house) at retirement is not a good plan.

My guess is that you are paying huge amounts into a 401k, IRA or other retirement planning investment account. You might consider temporarily cutting back those contributions to only what you need to receive any 401k match from your employer, and use that bump in take home pay for debt reduction. If that debt happens to be credit card debt, you will make more on your money by paying it off than by continuing to invest it.

I don’t know the specifics of your budget, but you need to figure out how to live sacrificially, cut your life style and get that $40,000 debt out of your lives. Also, if you have signed up for the student loans, you need to figure out how to minimize the damages. Have kids attend community colleges or state universities, commute from home (if possible) and work like dogs to pay their own ways.

I don’t like student loan debt, but if it happens, it should be their debt, not yours. If they own it, they will (hopefully) figure out how to keep it down. At any rate, they have lots of options (scholarships, work, job co-op, laying out every other semester, military, etc.) and time to pay it down. You don’t.

You asked for my opinion, so here it is. I hope this helps.”

OK Readers: your turn.  How would you advise this family?

Because I am in Mexico on a mission trip, I will not be able to respond to your comments for at least a week, but I look forward to reading them.  Thanks!

Did you know you could actually borrow from your 401(k) or 403(b) and pay it back without penalty?

The IRS permits you to take a loan from your employer sponsored retirement plan (not available for IRAs), as long as your employer’s plan allows loans.  However, just because this option is available, doesn’t mean it’s a good idea.  Knowing the impact of borrowing from your retirement account is important to understand before pulling the trigger.

Rules For Borrowing

The IRS generally requires you to be 59 ½ to access your retirement funds, but has made special provisions for borrowing.

• Plan must allow loans

You employer is not required to allow loans from the 401(k) or 403(b) plan. If loans are allowed under the plan, you can visit your HR office to obtain the paperwork or contact information for the plan sponsor who would draw up the loan from your account.

• Maximum Term is 5 Years

Most plans will allow you to customize the length of the loan from 1-5 years. Currently, IRS rules will not allow you to pay back the loan for more than 5 years.

• Maximum Loan Amounts

You can borrow up to $50,000 or half the value of your account – whichever is the lesser of the two. For example: If you have $90,000 in your 401(k), you can borrow $45,000 because this is half or the balance and it is less than $50,000. If your balance was $120,000, you can borrow a maximum of $50,000.

• Minimum Loan Amount

For many retirement plan, a loan minimum of $1,000 is common. Check with your plan sponsor to see what the minimums are for your specific plan.

• Fees and Charges

Employer retirement plans can charge a fee to administer the loan.  Generally there is a set up or initiation fee that can be from $100 – $200 and is usually added to the borrowed amount.  In addition, there are sometimes annual fees for maintaining the loan, and these can vary from plan to plan.

Pros of Borrowing From Retirement Account

• No Early Withdrawal Penalty or Taxes

Borrowing from your retirement account allows you to avoid the 10% penalty of withdrawing your funds before reaching 59 ½ years of age. Since the funds are still considered as a part of your retirement plan, you are not taxed on the funds you borrow.

• Low Fees and Interest Rates

Most retirement plan loans will have low rates and reasonable fees compared to a personal loan at a bank or credit union. (See the Fees and Charges above)

• Pay Yourself Interest

One of the nice parts of borrowing from your retirement account is that most of the interest goes right back into your account.  It’s as if you are paying yourself the interest that should have been accruing.  I’ve seen some plans that have interest rates of 5% but 4% goes into your account and only 1% is kept as administration fees – translating into basically a 1% loan!

Cons of Borrowing From Retirement Account

• Contributions May Be Frozen

Sometimes plans will force your contributions to be stopped for the term of the loan.  This makes a loan unattractive because it means your retirement account will lose momentum and it can really impact your ending balance.

• Defaulting on Loan

Although defaulting on your loan doesn’t hurt your credit, it does turn the loan into taxable income.  This means if you default on a $20,000 loan, you are responsible to pay taxes on the extra $20,000 now added to your income and that might just push you into a new tax bracket.

• Cannot Make Additional Payments

Many retirement loan repayment plans don’t allow you to make extra payments to your loan.  You can either make the payments or pay it off in full.  Saving those extra payments until you can pay it off in full is a good strategy for paying it off before the term.

• Accessing Long Term Savings is Dangerous

Let’s face it; Americans don’t have enough saved for retirement as it is. Tapping into your retirement account for any reason can be dangerous for your financial future, especially if your employer freezes contributions during the term of the loan.

Borrowing from your retirement plan can be a good option if used correctly. It can also be a terrible decision if you aren’t disciplined. If you’re borrowing to pay down credit card debt, take some time to really think about the reason you’re in credit card debt in the first place. If you’re borrowing for college, I suggest considering a government loan first or to look into other saving options first.

Have you ever borrowed from your retirement account? In your opinion, what would be a good reason to borrow?

Tim is a personal finance writer at Faith and Finance a Christian financial help blog that provides financial insights for individuals, businesses, and churches. Outside of finance, Tim enjoys spending time with his wife, playing the saxophone, reading economics books, and a good game of RISK or Catan. Find him on Twitter and Facebook and subscribe to the Faith and Finance RSS feed.