You need money and you need it now. Whether it’s for a major medical expense or a new roof on your house, you find yourself with a necessity for more cash than you have available.
You lose sleep figuring out how to pay for these things. Then you wake up in the middle of the night with a lightbulb moment and declare, “I’ll take a loan from my 401(k)!” feeling all proud of yourself for thinking outside of the box.
Hold up a sec. Yes, this is a viable option, but do you know the risks involved with taking out a loan from your 401(k)? We already looked at the cost of withdrawing early from your 401(k). Now let’s look at the details involved with a 401(k) loan before you make a boneheaded decision that could hurt you down the road.
1. Purpose or Convenience
Are you being short-sighted? Why do you even have a retirement account? It may feel like you’ve won the lottery when you need money and there it is, in an account with your name on it. But that money doesn’t exist to get you out of a pinch.
You contribute to a 401(k) to save money for your retirement, plain and simple. You may think you need the money now, but you won’t be so pleased with yourself when you are 80 and living on the edge financially. Instead, create an emergency fund and tell yourself your 401(k) is off limits.
2. The Fine Deets
First, if you take a 401(k) loan, you are subject to double taxation on the interest. You don’t pay taxes on the money borrowed (hallelujah!), but the loan will be repaid with after-tax funds.
Then, and this is the fun part, when you withdraw your funds in retirement, you are taxed again.
It gets better though. Regardless of how much your loan is, you will need to pay an origination fee back to the plan, usually $75. If you borrow $1000, that’s 7.5%. And yeah, the interest you pay goes back to your account, but that’s money you could have invested for more growth, which leads us to reason #3.
3. Stealing From Peter To Pay Paul
In this case, you are stealing from your future self to have the money on hand today. When you draw from your retirement savings to cover a debt or expense today, you lose out on significant growth potential and compound interest down the road.
Depending on how old you are, you may never be able to rebuild your savings. It may seem convenient to use your retirement savings in this way, but don’t fall prey to a short-term perspective. It’s true that interest rates for 401(k) loans are often low and you get to pay back the principal and interest to yourself instead of some bank, but that does not take into consideration the real cost of the loan, the opportunity cost of compound interest. Borrow only if you must.
4. Assuming Makes An Ass Out Of You And Me
How long are you planning to stay at your job? Considering Americans often change jobs more than eleven times throughout their career, with half of those job changes occurring before age 25, you may need to think long and hard about how long you are planning to stick with your current employer.
If you bite the bullet and are lured in by that attractive 401(k) loan, you could be in deep water if you are forced to pay it back sooner than you planned. Say you get a lucrative job offer from a different company that would be foolish to walk away from. You triumphantly accept the new job and then get an urgent email from the HR department at your current company. You open the email and the blood drains from your face.
You are in deep shit because you didn’t realize (or didn’t care) that if you left your job, you would have to pay back the entire loan in 60 days. If you don’t, you have to pay income tax on the borrowed amount AND a 10% penalty if you are under 59½. Where are you going to get that money?
5. Repaying Vs. Contributing
Depending on your 401(k) plan, you might have to stop contributing to your plan while you are paying back the loan. Think about it. Will it take you the full five years to pay back your loan? That’s five years you aren’t building wealth for your golden years.
Don’t even bother doing the math. It’s a lot of money, enough to create a big problem for you down the road. Plus, that’s five years of not using your 401(k) as a strategy to reduce your taxable income. (*Hot tip: To be strategic with your 401(k), download our free 401(k) ebook here).
6. Budget Buster
Your loan will most likely be repaid through paycheck deductions. If your loan is hefty, the deduction could be higher than what you were contributing initially, reducing your take-home pay. Your payments are not tax-deferred like your contributions were, so your taxes will increase, lowering your final paycheck amount even more. Get a calculator and make sure your budget can handle the difference.
Here’s the thing guys, your retirement plan is not your piggy bank. If it seems too good to be true, it is. Be smart and talk to someone who knows what they’re doing and take control of your money. Do you know what will help you keep your eyes on the retirement prize and avoid the “need it now” temptation? Having a thorough understanding of where you are at on your retirement planning journey. Compare yourself to this retirement planning checklist then chat with me for 15 minutes about your thoughts.
For many people, a 401k is their largest retirement account. It deserves your undivided attention. Download our Ultimate 401(k) Guide for a step-by-step strategy to master your 401(k), including a prioritized checklist. It’s free!
Pathway founder and principal Greg Brown is a fee only financial advisor with broad financial planning and investing expertise. Greg’s financial advice has been featured in publications like Yahoo Finance, Bankrate, Investopedia (all articles here), Wall Street Journal, and USA Today. He holds a master’s degree from the University of Chicago and a mechanical engineering degree from Michigan State University. Prior to Pathway, Greg was a lead analyst at Morningstar and previously held engineering roles at Dell (including a US Patent).
Also published on Medium.