Life can throw us curve balls. You may run into large medical bills, the unplanned need to buy a car, or even a “once-in-a-lifetime” opportunity. (Notice that I put that one in quotes). You sit down and look at your accounts and see that the largest account that you own is sitting in your company 401(k) plan. Why not take some of your own money? It is your money. Oh good, you can easily borrow your own money and pay yourself back. What a great concept…right? You would rather pay yourself the interest than some bank or credit card company…right again?
The way a 401(k) plan loan works is fairly simple. You designate how much you want to borrow. This is typically limited by the IRS to 50% of the account value or $50,000, whichever is smaller. Your plan will cut you a check from your own money. You will then be required to pay back a part of the note with each paycheck plus interest. The interest rate will be a fair rate based on current rates on other loans. Once you have paid it off, that monthly payment should then convert to a normal contribution like you were doing before you took the loan out.
There are three reasons that to steer clear of borrowing from your 401(k):
- The potential penalty is too high. While you can borrow from your plan pretty easily (much too easy in my opinion), if you should lose your job you may be forced to cough up the entire loan amount in 30-60 days. After all, if you are no longer working, they have no easy mechanism to get your payments like they did while you were working. If you cannot afford to pay it back it can be deemed a taxable distribution. You may end up owing the tax due based on your tax bracket plus an additional 10% penalty if you are younger than 55 years old. This one potential drawback is usually enough for me to say no to 401(k) loans.
- You may miss out on opportunity growth. When you remove the money from your plan as a loan it is no longer invested in the market. While you may think that the only loan cost for you is the interest rate you are being charged, there is another cost that could end up being a much larger expense. If the stock market continues to rise while you have your money “out on loan”, that portion of your 401(k) plan may not rise with the market. Let’s say that you took 3 years to pay the loan back and the market grew by 6% a year. That could cost you an additional 6% per year for your loan. This opportunity growth could actually end up costing you a lot of money.
- You could incur double taxation. You are most likely investing money into your 401(k) plan on a pre-tax basis. This means that your taxable income for the year is reduced by your 401(k) contribution. When you pay back a loan, you are doing so on an after-tax basis. This means that your taxable income may be higher in years that you are paying back a loan. That in itself is another cost that you need to factor in. Then, when you eventually distribute the money from your plan, it will be taxed again. This is double taxation: taxed on the way in and on the way out. This is not the most efficient way to invest for your retirement.
So, while it may be tempting to tap your retirement funds, try to stay away. Get yourself in a position now to not have to rely on using your retirement funds until…well…retirement.