Should you ever take a loan from your 401(k)?
If you are facing a large amount of debt or a big unexpected expense and have a sizeable amount of money built up in your retirement account at work, you might be tempted to borrow from your 401(k). But is that the right thing to do?
It’s a question money expert I get all of the time, and feel very strongly about the answer:
Almost 100% of the time people have asked me about borrowing from their 401(k), the answer is “No!” That has to be the last option and something you do when you’re out of all other possibilities.
When people do borrow from a 401(k), historically it means that they end up with not near enough money to live on in retirement.
That’s scary, considering that according to a study from the Investment Company Institute, nearly one in five people who are eligible have a loan against their 401(k). Here are the main reasons it’s not a good idea:
You reduce or stop your contributions
Research from Fidelity says about a quarter of people who take a 401(k) loan reduce how much cash they put away for retirement while they’re repaying the loan. That’s because they’re struggling to make those payments back. Worse still, 15% of people end up stopping contributions completely within five years of taking a loan.
‘I’m paying myself back’ rationale
When people do a 401(k) loan, they tend to justify it by saying, “Well, it’s my money — I’m paying myself back.” But the thing is, you are paying yourself back with after-tax money that will be taxed again when you retire.
You’d better keep your job
Also remember that if you leave a job — whether they fire you or you leave on your own — the money on that loan is due pretty quickly. If you can’t pay it, you trigger a HUGE tax bill, plus penalties.
In the past, you generally had just 60 days to pay back the loan before the taxes and penalties would kick in. Under the new tax law, you have until the due date for filing the taxes for the year in which you leave your job.
Real cost is opportunity cost
In the long run, the stock market has a lot more up years than down years. If you’re not as invested in the market because you’ve reduced or stopped your contributions during payback, you’re missing a lot of the gain that takes place over time.
I’ve told you in the past about the heavy taxes you have to pay on your money when you tap into it before retirement. But the big cost here is an opportunity one. If the money’s not there, it has no chance to grow and multiply over the years.
Net effect is less in retirement
A 401(k) loan today can mean a big reduction in what you have to live on in retirement. You might either have to work more years to make up for it or be in near-poverty during retirement.
Even though the interest rate on that 401(k) loan seems really good, the problem is that you are devastating your future. You are taking money out of that account that you will never recover.
Final thought
Although it may look attractive, a loan from your 401(k) is almost never a good idea.