As more and more people feel the pinch of desperate times, they consider taking a 401(k) loan to finance a wide variety of needs and wants. But, does this make financial sense? Should you ever take a 401(k) loan? Isn’t it better to borrow from yourself rather than pay someone else interest? What if this is my only option? These are questions I will help you sort out!
Does a 401(k) loan make financial sense?
Those who have 401(k)s at work typically have the ability to take a loan. While this loan option is generally available to all participants, this doesn’t mean this is a smart choice. Yes, the stock market value has been cut in half – so too may the balance of your 401(k). However, borrowing from your 401(k) could prove to be damaging to your future wealth.
Many 401(k) plans do not even allow you to take a loan. When they do, they often allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less. How does the money get paid back? The money you borrow plus interest is collected via your paycheck. The time to pay it back is usually set anywhere from 1 to 5 years. Typically the only exception is if you use a 401(k) to buy a home, you may have a longer term option.
401(k) Loans Should Be a Last Resort
Here’s five reasons why you should try to avoid 401(k) loans at all costs:
1) Can you handle the load? You may be tempted to lower your current 401(k) contributions. Can you handle repaying your loan and contributing to your 401(k at the same time?.
2) Missing the match: If you lower your 401(k) contributions, you may lose out on some or all of the company match.
3) Deadly distributions: If you can’t repay the loan because you become disabled or lose your job, it becomes a distribution. This may be subject to taxes and a 10% penalty if you are under age 59½. Also, if you lose your job, you typically only have 60 days to repay the loan or it is considered a distribution. Ouch!
4) Losing tax advantages: When you take money out of the 401(k), it is no longer tax sheltered. Additionally, there are no tax benefits for the interest you’re paying on the loan.
5) Lost magic. The magic of compound interest is amazing – interest earning interest. However, when you take money out of your 401(k), you lose some of the time value of money (compounding). For example: $10,000 invested today will grow faster than $10,000 invested 10 years from now. If you wait 10 years to invest, you lose out on 10 years of time value. Additionally, the $10,000 will be less in 10 years because of inflation.
The bottom line: every 401(k) loan has negative consequences. This option should be used if no other resources are available and you are facing a severe hardship. Over my 14 years as a financial advisor, I have seen it all! I have seen people use their 401(k)s to finance keg parties, buy presents, purchase automobiles, take lavish vacations, and buy all kinds of toys. Short-term pleasures come at a great long-term price!
Well, I’m paying myself interest
If you think this is true, watch out for double taxation! Here’s how it really works: When you pay back a 401(k) plan loan, the administrator of your 401(k) plan places principal and interest back into your 401(k) account after each pay period. So this appears like you are paying yourself interest. Technically, you are. However, in order for you to pay that interest, you need to earn money (your paycheck) then pay income taxes, then you pay the interest with dollars you just had to pay taxes on. To make matters worse, when you withdraw those dollars that were just taxed later on they get taxed again as taxable income. So in reality, you pay taxes twice on that money!
*Please note Roth 401(k)s have different tax rules.
So after all this; My point is why harm your retirement fund? Borrowing from a 401(k) does not make financial sense. During dire circumstances, you may be left when with no choice, but when you have other options available, I suggest you seek alternative arrangements that are less detrimental to your future financial health.