8 Reasons to Avoid 401(k) Loans

Reviewed by Eric EstevezReviewed by Eric Estevez

Dipping into the savings in your 401(k) plan is a bad idea, according to most financial advisors. But that doesn’t deter nearly one in three account owners from raiding their funds early for one reason or another.

Such a loan can seem alluring. Most 401(k)s allow you to borrow up to 50% of the funds vested in the account or $50,000, whichever is less, for up to five years. (One exception to the five-year rule is if the loan is for your primary residence. And, some plans include an exception that allows the account owner to borrow up to $10,000 even if 50% of the vested funds is less than $10,000.) Because the funds are not withdrawn, only borrowed, the loan is tax-free. You then repay the loan gradually through payroll deductions, including both the principal and interest.

Key Takeaways

• Most 401(k) plans allow you to borrow up to 50% of your vested funds for up to five years, at low interest rates, and you’re paying that interest to yourself.
• Before borrowing, consider that you’ll have to repay the loan with after-tax dollars, and you could lose earnings on the money while it’s out of the account.
• Should you lose your job, you’ll have to repay the loan more rapidly or, failing that, pay taxes on the money you withdrew.

The interest rate on 401(k) loans tends to be relatively low, perhaps one or two points above the prime rate, which is much less than most pay for a personal loan.

Also, unlike a traditional loan, the interest doesn’t go to the bank, it goes to you. Since the interest is returned to your account, it could be argued that you’re paying yourself for the loan.

These distinctions prompt select financial counselors to endorse retirement-fund loans, at least for people who have no better option for borrowing money. Many more advisors, though, counsel against the practice in virtually all circumstances.

Here are eight reasons you probably shouldn’t take out a 401(k) loan.

1. Repayment Will Cost You More Than Your Original Contributions

The leading advantage of a 401(k) loan—that you’re borrowing from yourself for a pittance—looks dubious once you realize how you’ll have to repay the money.

The funds you’re borrowing were contributed to the 401(k) on a pre-tax basis (if it’s a traditional 401(k) account rather than a Roth account). But you’ll have to repay the loan with after-tax money.

Say you’re paying an effective tax rate of 17%. Every $1 you earn to repay your loan leaves you with only 83 cents for that purpose. The rest goes to income tax. Put another way, making your fund whole again would require roughly one-sixth more work than the original contribution.

2. The Low Interest Rate Overlooks Opportunity Costs

When you borrow money from your account, it won’t be earning any investment return until it’s repaid. Those missed earnings need to be balanced against the supposed break you’re getting for lending yourself money at a low interest rate.

“It is common to assume that a 401(k) loan is effectively cost-free since the interest is paid back into the participant’s own 401(k) account,” says James B. Twining, CFP®, CEO and founder of Financial Plan Inc., in Bellingham, Wash. However, Twining points out that “there is an ‘opportunity’ cost, equal to the lost growth on the borrowed funds. If a 401(k) account has a total return of 8% for a year in which funds have been borrowed, the cost on that loan is effectively 8%. [That’s] an expensive loan.”

3. You May Contribute Less to the Fund While You Have the Loan

Some plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn’t stipulate this, you may be unable to afford to make contributions while you’re repaying the loan.

Such a freeze will deprive the account of money that should, in the long run, multiply many times in value through compound earnings. Most calculations suggest that your money will double, on average, every seven years while invested. The gap will be wider still if your skipped contributions lead to missed matches by your employer.

Warning

If you lose your job or leave it, your loan will become due sooner. If you can’t repay it in time, it will be treated as a taxable distribution. If you’re under 59½ years old, you’ll also pay a 10% penalty.

4. If Your Financial Situation Deteriorates, You Could Lose Even More Money

The drawbacks above assume you’ll be able to make the scheduled payments to your fund on time and without undue hardship. In fact, the vast majority—87.7%—are able to do just that, according to Bank of America’s Participant Pulse survey of retirement accounts.

However, should you be unable to repay the loan, the financial implications go from bad to worse. If you default on a 401(k) loan, the loan is converted to a withdrawal. Unless you qualify for a hardship withdrawal, the outstanding loan balance will be subject, at minimum, to taxation at your current income tax rate. If you’re under the age 59½ you’ll also be assessed a 10% early withdrawal penalty on the amount you’ve borrowed.

5. A Job Loss or Departure Resets the Repayment Clock

If you quit or lose your job, you’ll only have so much time to repay an outstanding loan from your 401(k). The federal deadline is the due date of your next federal tax return.

You’ll be forced to come up with the outstanding balance in less time, most likely, than the five years you customarily would have. If you can’t repay the money, the loan will be treated as a withdrawal, with all of the attendant implications for paying income tax and penalties.

In any case, the presence of a loan you’d have trouble repaying early could handcuff you to your current job or force you to pass up a better opportunity.

6. You’ll Lose a Financial Cushion

Your 401(k) balance may one day represent the last possible weapon to stave off financial disaster. If you exercise the nuclear option and tap the money now, that money won’t be there if a true emergency strikes.

7. A Loan May Encourage Poor Financial Practices

Borrowing from your future should encourage you to examine how you got to this point in your finances. The need to borrow from savings can be a red flag, a warning that you are living beyond your means and need to consider changes to your lifestyle.

When you can’t find an alternate way to fund your lifestyle (other than by taking money from your future), it’s time to re-evaluate your spending habits. That includes creating, or adjusting, your budget and making an orderly plan to clear any accumulated debts.

8. You’re Unlikely to Repay the Loan Quickly

Advisers warn against having high confidence that you’ll repay a loan from your 401(k) in a timely way—that is, in less than the five years that you’re usually allowed to take out the funds. “People think that they will make up a withdrawal later, but it pretty much never happens,” says Chris Chen, CFP®, wealth strategist, Insight Financial Strategists LLC, Newton, Mass.

Can I Borrow Money From My 401(k)?

Yes, you can borrow money from your 401(k), but it’s unlikely to be a wise financial decision. It looks like a low-interest loan, and in any case, you’re paying the interest to yourself. But keep in mind that you’re robbing your future self. You’re also tying yourself to your current job or risking a big tax bill if you don’t repay the loan almost immediately.

A 401(k) loan should be an option only in a true emergency.

What Are the Requirements for a 401(k) Loan?

A 401(k) loan is subject to a limit of $50,000 or half of your account balance, whichever is less. Some plans allow an exception to this rule, stating that you can borrow up to $10,000, even if half of your account equals less than $10,000. The loan is also subject to a repayment period, which is typically five years.

How Soon Do You Have to Pay Back a 401(k) Loan?

If you’re working for the same employer and have kept your job, you’ll probably have five years to repay the loan. The tricky part comes if you part ways with your company for whatever reason. In that case, the entire loan balance will be due by the next tax day in April.

The Bottom Line

Taking a loan from your 401(k) is not a good idea, short of a dire emergency. But that doesn’t stop some account holders. According to data from the Transamerica Center for Retirement Studies, 15% of plan holders withdraw money outright from their account, often using hardship provisions. One in four people borrow temporarily from their 401(k) or a comparable account such as a 403(b) or a 457.

Still, borrowing from your 401(k), most financial advisors say, goes against almost every time-tested principle of long-term investing.

Read the original article on Investopedia.