It is tempting for a lot of people with a cushy 401 (k) to borrow from it, but taking a loan from your 401 (k) comes with more problems than it solves. While there are ways to take money right out of the account, such as the hardship provisions, many more people decide to borrow from the 401 (k) in order to keep their retirement savings while digging out of a financial situation in the present. While that sounds like a good plan on paper, borrowing against your 401 (k) isn't the solution you think it is.
7 Reasons Why Borrowing From a 401 (k) is Bad
There are many reasons why you should borrow from your 401 (k), but these seven are the primary problems you will face or consequences from the loan to keep in mind before taking action:
Loan Repayment Costs More
A 401 (k) loan is tempting primarily due to people thinking they're only borrowing from themselves, but not remembering that you'll be required to pay yourself back for the loan with after-tax money. Remember, you contribute to your 401 (k) with pre-tax money, and depending on your tax bracket, every dollar you earn isn't really a dollar. What that means is it'll take more to pay back the loan per dollar than it does to invest in the fund itself. Your repayment could easily be limited to .76 cents out of every dollar taken out.
Borrowing Means Less Invested
Some 401 (k) plans prohibit you from making further contributions until the loan's balance is repaid, costing you additional retirement money while paying off the loan. Freezing additional funding, in the long run, costs you multiples of value that could've been earned through compound earnings, which is a key benefit of having a 401 (k) plan.
Defaulting on Retirement Savings
The previous two reasons borrowing from your 401 (k) is a bad idea are based on the assumption you'll be able to make your repayments. If you become unable to make those payments then your financial situation can worsen substantially. When you default on the loan it is then considered a withdrawal and the outstanding loan balance will be subject to your current income tax rate and a 10% early withdrawal penalty will be applied.
Job Loss & Repaying the 401 (k) loan
Whether you quit your job or otherwise no longer have it, you'll have a mandated time to repay it, currently, you have till your next federal tax return if it's at least 60 days after you depart from the job. This restrictive time period to pay your 401 (k) back means you could be bound to a job you no longer want to be at in order to keep the 5-year repayment period, as well.
Perpetuating Poor Financial Planning
Borrowing from your 401 (k) is, essentially, borrowing against your future and beginning a bad habit of "borrowing from Peter to pay Paul." The need to borrow from savings is a red flag, telling you that you're living above your means and making poor financial planning decisions. Remember, taking a loan from your 401 (k) is taking your retirement savings in the hopes you can rebuild it later.
Loan Interest
While the interest loan rate on a 401 (k) is low and the interest paid goes to you instead of a commercial lender or bank, some argue that the cost of borrowing from the fund is paying yourself back for using the money early. The problem here is that your 401 (k) plan is subject to change and the interest rate is subject to your employer.
A Double Taxed 401 (k) Repayment & Loan
Having borrowed against your 401 (k) means tax time will be more hard-hitting than you're accustomed to. When you repay the loan amount back you are paying the after-tax amount and not the pre-tax, as mentioned earlier. You will also be taxed when you withdraw the funds after you've retired, paying a second tax on the same money. Essentially, you're paying taxes when you put the money back into your account and when you take it out as retirement savings.
Borrowing Isn't the Best
Those are only the primary reasons why 401 (k) loans are a bad idea. Instead, seeking a financial coach for helpful money tips and better planning would yield better results, or apply for a personal loan instead of borrowing from your 401 (k). We at Canopy Credit Union help our members reach their financial goals without putting them in a dire situation and provide both financial coaches, as well as other loans.
Keep your retirement savings for retirement, you'll be happy you did when it's time to cash in on it.
Learn more about your retirement savings options with Canopy's fuduciary investment partner here.