Here’s Why You Should Think Twice Before Borrowing from your 401(k)


Borrow from Retirement ?

It’s a secret that is probably best kept that way. Depending on the specific plan that your employer sets up, you may be able to loan yourself money from your 401(k). There are advantages to doing this under the right circumstances but like any financial choice, there are some hidden problems with loaning money to yourself and those negatives can add up to cost you a lot of money. Let’s take a look at how you can borrow from your 401(k) and see if the advantages outweigh the financial impact.

How it Works

First, remember that under the plan that your employer set up, you may be ineligible. Not all plans offer this service and that might be to protect you from yourself. If your plan does offer it, The IRS allows you to borrow up to $50,000 of your 401(k) funds or up to 50% of the fund’s balance without treating it like a distribution. You still have to pay the money back with interest but since you’re the bank and you’re the borrower, the interest rate is very competitive, often at 1% or slightly more but much more attractive than a bank loan.

Unless you’re purchasing a new home, you have five years to pay back the loan but if you lose your job, you only have 60-90 days for repayment. If you don’t, it is treated like a distribution and you’re charged taxes and hefty fees to withdraw money from your 401(k) before the age of 59½. You don’t have to pay the fees that come with applying for a loan and approval is fast. If you apply for a 401(k) loan today, you could see the funds within two or three days.

The Problems

From a tax standpoint, this is a bad idea. Before your employer took taxes out of our paycheck, they contributed money to your 401(k) which meant that the money when straight in to your 401(k) before the government got their hands on it. Don’t be fooled, though. The government gets their piece when you take distributions later on in life.

If you take a loan from your 401(k), you’re going to pay it back with money that has already been taxed. Any money sitting in your bank account was already subject to payroll tax and then when you retire, you’re going to pay taxes on that same money again.

You’re also not making money on those funds when they’re outside of your 401(k). A Wall Street Journal study found that baby boomers who have reached retirement age are finding that they don’t have enough money to live at the level they would like. In fact, the average couple would need $36,000 to live at 85% of their past income but their 401(k) is only going to provide a little over $9,000. You need all the money you can get working as hard it can.

Bottom Line

Borrowing from your 401(k) is appropriate when you come up against a financial emergency. Refinancing your home, purchasing a new car, or a dream vacation is not an emergency. You cannot afford to have those funds outside of your account not making money for you.

As a general rule, say no to 401(k) loans unless it’s a situation where there is no better alternative.