If you are in a financial bind, seeing the money sitting in your 401k retirement account can be tempting. It is a tempting source that you may consider tapping in order to help alleviate some of your financial problems. However, your 401k retirement plan is there to be your safety net in retirement. Your 401k is not designed to be your emergency fund now. It may seem like it is not a big deal because you are essentially borrowing the money from yourself with interest, but it does not really work that way. There are dangers of 401k loans. Here are some dangers of why you should avoid taking a loan from your 401k retirement plan.
You Must Repay Your 401k Loan
When you take out a 401k loan from your retirement plan, you must repay it. Defaulting on the loan can have serious tax consequences that can erode all of your hard work that took years to build up. Your employer is required to treat your 401k loan like any other loan or financial agreement. You must set up a repayment plan that starts immediately after taking the loan. Many 401k retirement plans now prevent future contributions to the 401k until the loan is repaid. This prevents you from continuing to grow your money and can serious degrade your future earnings that you will not be earning on the money you borrowed and on any contributions you are not allowed to make while you repay the loan. If you are lucky, you will still be allowed to contribute money to your 401k plan while repaying the loan. Or, you could consider forgoing contributions in favor of early loan repayment.
Loan Repayments Eats Into Your Budget
Loans taken out of your 401k retirement plan are also repaid through payroll deductions. So, when you take out a loan, realize that you are going to lose some of your take-home pay in order to repay the loan. As a result, you can quickly go down a slippery slope where you no longer have enough income to cover items in your family’s monthly budget. You could be forced to take out additional loans which could start a dramatic downward spiral.
Penalties For Non-Payment Of Your 401k Loan
If you do not repay your 401k loan back to your retirement plan, there are huge penalties involved. Non-payments are considered early 401k withdrawals, and as such they are subject to a 10% if you have not reached the age of 59 1/2 years-old. You will have to report the withdrawal as ordinary income on your tax return and not as investment income. If you are in the 28% tax bracket, this means you will pay 38% to the Federal Government and then state taxes which can be approximately 10% (depending on your state). Your loan could end up costing you almost 50% in taxes and penalties. And, you could be in a bind if you already used the loan to pay for something else. How will you come up with that money?
Also, if you leave your job, you have 60 days to repay the loan in full. If you do not repay your 401k loan, then it falls into the early withdrawal category and you will owe taxes and penalties on the money that you withdrew. This applies whether you quit or were let go from your job. Losing your job while having an outstanding loan is definitely one of the biggest dangers of 401k loans. There is also the loss of future income that you will not earn on your investment because that money is not active in the market when you borrow against it. You will lose out on years of principle and compounding interest that can have a far greater affect on your retirement.
Finally, your 401k is a protected retirement account. If you cannot pay your bills, there may be other options that you should consider first. Is there another option that you can find money in a pinch? What about borrowing money from friends or family? What about trying to tap your home equity? Have you considered an unsecured loan from Lending Club
? While these may not seem like the ideal solution, taking a loan from your 401k retirement plan is not ideal either. But, these options show that a 401k loan is not your only course of action. You may have other options if you look around.
I was just advising a friend at work about this. He wanted to borrow against his 401k for a house, but I swayed him from it. You illustrate some excellent points here. I don’t think people realize the possible tax consequences or penalties you could end up paying. Unfortunately if you want to make a large purchase, you’ll just have to do what the rest of us do by saving and budgeting for it!
I am not in favor of borrowing against retirement money. But if the situation demands this should be one option as repayment interest rate would be lower than other routes such as HELOC. Point is you should pay back in full to avoid penalty.
Thank God I don’t have that problem. Plus I leave my retirement alone. I don’t even think about it.
Hey Hank, you make a great point about 401k loans that not many people think about. 401ks are meant for retirement but too many people treat them like a piggy bank and live to regret it down the road.
As one of those people who accrued a large penalty for a 401K loan turned withdrawal—I can tell that it is totally painful! At the time, however, like a lot of people, we were out of options–and we paid for it big time, and are still rebuilding our nest egg.
I think under normal circumstances, no one should touch a 401K, considering that almost half of what you withdraw might go to the tax man, it definitely is something to avoid like the plague.
Borrowing against your 401k should most definitely be your last option. There are cases where it can be a better option than a conventional loan if you repay the balance of course.