Taking a loan from your 401(k) plan may seem like a good idea when you’re hit with a financial setback, especially when borrowing money from a bank may be difficult and credit card rates are sky high. You may have heard from co-workers how easy it is. Just be sure to take all the risks into consideration before borrowing from your future retirement.
1. Lost benefits.
Some employers may not allow you to make new contributions to the plan while you have a loan outstanding, or for a fixed period of time after the loan. Or you may not be able to afford continued contributions while you have to make loan re-payments. When you’re not contributing to the plan, you lose more than just those missed contributions. You’ll miss out on the tax reductions of pretax 401(k) contributions and you could lose any employer match you were previously receiving as well.
2. Power of compounding is reduced.
Compound interest is a key component to growing your investments. Basically, when your 401(k) investment earns a positive return that is then added to the principal so that new (larger) total earns even more return next period. As this repeats over time the effect is significant. If you take a 401(k) loan, the power of compounding is reduced because you have removed a chunk of the principal. While you are slowly repaying your loan, the principal is building back up, but your long term compounding takes a hit and you’re left with less at retirement than you would’ve had.
3. Double taxation.
If you make pretax contributions to your 401(k) plan and then withdraw those funds through a loan, the loan repayments are made with after tax dollars (that’s the first tax). Then when you take a distribution at retirement, you pay income tax on that amount again (the second tax).
4. Reduction of your take home pay.
Once you have initiated the loan, your employer will establish a repayment plan, typically 1 to 5 years. The payments usually begin shortly after the loan is taken via deductions from your paycheck, reducing your take home pay. How does this impact your other monthly obligations? Can you afford this new loan payment?
5. Possibility of default.
If you can’t repay the loan, it is considered defaulted. And if you quit your job or change employers, the full loan amount is due. If you cannot repay your loan within the specified time period, the outstanding loan(s) will be in default and will be deemed a “distribution” and may be subject to early withdrawal taxes and penalties.
Each plan has their own rules based on IRS guidelines, so be sure to check your plan details if this is something you are considering. There are times when a 401(k) loan is an ok option, but you need to be aware of the risks. They aren’t free money – you pay the cost in the long run.