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 401k 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.
During my time as a Certified Financial Planner™ I've seen some serious financial emergencies that warranted a 401k loan as a last resort. And, I've also seen some straight up terrible decisions that would make you shake your head. Whatever the reason you might be considering a 401k loan, you need to know what you're really getting into. Doing so can make the difference between a sound retirement nest egg and financial future filled with uncertainty and regret.
401k Loan – 3 Reasons Not To Borrow
1. A 401k loan isn't cheap so consider the 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.
Don't underestimate how significant fees can be. When you are faced with a decision to pull money out via a 401k loan, it is likely that fees are not high on the list of concerns. But they should be. This is especially the case if you will be taking multiple loans. I have personally seen many situations where as soon as one 401k loan is paid off, another loan is taken. This cycle repeats itself over and over. Don't fall into this trap.
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2. Borrowing will diminish your retirement 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.
Don't be fooled by the “paying yourself back with interest” rational. It's a bad deal. When you have money invested in your 401k your total return is comprised of reinvested dividends and increases in the share price over time. When funds are pulled out via a 401k loan, not only are they potentially missing out on rising share values, but you're no longer receiving the dividends. Real wealth is built over time so the key is to remain invested.
3. Taxes and potential penalties can cost you.
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.
A 401k loan can be problematic and the decision to borrow shouldn’t be taken lightly. It is important to acknowledge that borrowing from a retirement plan via a 401k loan 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.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.
What about borrowing from an IRA?
One of the most common questions I get is if you can borrow from an IRA. The short answer is no. You can take withdrawals from your IRA at any time, but there is a catch. Assuming all of the contributions you made were tax deductible, the withdrawals would be taxable as ordinary income. If you are under age 59 ½, you would likely be subject to an early withdrawal penalty from the IRS. When added together, the taxes and penalties can take a huge bite out of your IRA.
There are exceptions to the early withdrawal penalties. I wrote an article called Avoiding The IRA Early Withdrawal Penalty which goes into more detail on this subject. There is also a way the IRS allows you to take substantially equal periodic payments which can qualify as an exception to the early withdrawal rules.
Just because you can take money out of an IRA, doesn’t mean you should. For many people, it is an easy place to look when funds are needed. It’s almost too easy to withdraw from an IRA and it can lead to less than optimal financial decisions.
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Your guide to 2020 tax rates, retirement contributions, and Social Security.