A 401k loan, while well intended, can be the ruin of a great retirement savings plan. When a 401k plan allows this option, participants are often able to borrow up to 50% of their account value up to a maximum of $50,000.
It is important to acknowledge that borrowing from a 401k could be a critical last resort in an emergency financial situation. I have no doubt that many people have used this option to overcome a period of financial hardship and are glad the loan provision was available.
The problem is that for many, the 401k loan is simply a way to access their funds early to spend on their “wants” as opposed to their most urgent financial needs. Borrowing from a 401(k) is easy. Too easy. There are no credit checks and failure to pay it back won’t wreck your credit, although it will do significant damage to your retirement savings.
1. Costs and fees:
There are often loan processing fees involved with 401k loans. The plan administrator may charge a fee to set up the loan and can even charge quarterly or annual maintenance fees. You will need to sell investments in your 401k account to fund the loan. This could result in short-term redemption fees if recently purchased or other transaction fees often buried in the prospectus. These fees add up and significantly add to the real cost of taking a loan.
2. Diminished savings:
When you borrow from a 401k, you pay yourself back with interest. Sounds great, right? The reality is that this money has been removed from long term investments that grow tax deferred. Now you have a loan payment back to the 401k and it will likely crimp your budget. The most likely place to cut back will be your pre-tax salary deferral contributions. That’s right. When you pay back the 401k loan, your loan payments are AFTER-TAX. Unless you’re able to continue the pre-tax salary deferral contributions you were making prior to the loan, you have dealt yourself a serious financial blow. You’ve likely lost the tax savings and traded them for after-tax contributions to pay back the loan.
3. Taxes and potential penalties:
If you terminate employment, your outstanding loan balance will be deemed a distribution if not fully repaid. This means whatever balance is outstanding will become fully taxable at your income tax rate and if under age 59 1/2 additional early withdrawal penalties can apply. This could result in paying over 1/3 of the loan balance to the IRS come tax time.
There are other considerations when managing your 401k. The decision to take out a loan is a big one. While it can be tempting to tap into your 401k via plan loans, remember that the effect on your retirement savings can be much more significant than you think. Proceed with caution.