You’re looking for a quick source of money, either to pay down debt or for emergency cash needs. At first glance, your 401(k) account might look like a tempting source for a short-term loan.
To be sure, borrowing against your 401(k) has advantages over many other type of loans. Loan rates tend to be low, as your creditworthiness is often not even considered. After all, you are borrowing your own money.
And because you’re borrowing from yourself, the money you pay back is really going back to yourself, including the interest! You can’t get that deal from the bank!
But tapping your 401(k) has several drawbacks, as summed up in a recent article on marketwatch.com:
- You can only repay the loan with after-tax dollars. The pretax contributions you make will not lower the loan balance. Because of this, many people will stop making pretax contributions until the loan is paid off. That can have a double whammy impact.
First, you are increasing your taxable income and therefore increasing the amount of taxes you will owe. And second, you lose out on the company match when you stop contributing.
- Another negative impact of repayment with after-tax dollars is you have to earn much more than the loan amount to repay it. For example, if you are in the 28% tax bracket, you have to earn $139 to repay $100 of the loan. And when you add in other payroll deductions such as FICA, you might have to earn over $150 for every $100 of outstanding loan.
- Your 401(k) is part of a lifelong investment plan. Its role is to grow through contributions throughout your working career pluscapital appreciation over time. When you take money out, you limit the ability of your account to grow.
- If you can’t repay the loan in time, it will be classified as a distribution and subject to income tax, as well as a 10% penalty if you are under age 59½. This could become very important if you lose or leave your job, as many plans then require you to repay the loan within 60 days. Yes, this applies even if you are laid off or fired, which might be exactly the worst time to try and come up with money to repay the loan.
Yet despite the many significant drawbacks, 401(k) loans are very popular. Aon Hewitt recently reported more than a quarter of plan participants (26%) have a loan outstanding. And given that most Americans have not saved nearly enough for retirement ($91,300 as of end of 2014, according to Fidelity), it is money we can ill-afford to tap early.
So when is it okay to take a loan against your 401(k)? When you are confident you’ll be able to repay the loan quickly and only if you have exhausted other loan sources, such as a Home Equity Line of Credit or even a credit card advance, which also rarely makes sense unless you can pay it back quickly.
But the best plan is to avoid such a dire circumstance, by building up a liquid emergency fund equal to at least 3 to 6 months’ living expenses. Consider the retirement savings sacrosanct.
Source: Here’s What Happens When You Take Out a Loan On Your 401(k) by Elizabeth O’Brien. Marketwatch.com, June 29, 2015