When you need extra money to pay some bills, make home improvements or buy a new car, a 401k loan may seem like the perfect solution. At first glance, it seems like a great idea to borrow money from your 401k account and pay interest back to yourself. However, in reality taking a loan against your 401k can put a significant dent in your retirement saving and could result in unnecessary taxes.
Most 401k plan providers allow employees to take loans against their 401k account of up $50,000 or 50% of the account value. The interest rate charged on most 401k loans is the prime rate, which is currently around 4%, plus 1 or 2 percentage points. Loans must be paid back in five years, potentially longer if you are borrowing to purchase a primary residence. Repayment is typically made via automatic payroll deduction and loans automatically come due if you discontinue employment.
The advantages of a 401k loan include the ease with which you can get your money. A 401k loan is a quick, no hassle process that doesn’t require a credit check or the completion of a time consuming credit application. The loan is automatically repaid from your paycheck and the interest rate is generally lower than what you would pay for a bank loan or a credit card. There is no income tax or penalty due on the money taken out for the loan and the interest goes back into your account.
On the surface this sounds like a great deal but there are significant disadvantages. The most obvious may be the opportunity cost of losing the chance to earn compounded returns on the money that you have borrowed. This can have a dramatic negative effect on the amount of money you have available at retirement. Additionally, while making payments on a 401k loan, most borrowers stop making contributions. This results in lost tax deductions and may cause you to miss out on your employer’s match, not to mention less money in retirement.
Another less obvious downfall is the double taxation on the interest. Your interest payments are made with after tax dollars and then you pay taxes a second time when distributions are taken in retirement. Additionally, you may have to pay taxes and penalties if you lose or quit your job before your loan is paid off. A 401k loan typically becomes due within 60 days of separation from your employer, regardless of the reason. If you are unable to pay off the loan you will owe regular income tax on the full amount plus a 10% penalty if you are under 59 ½.
Generally, you are better off taking out a bank or home equity loan or postponing consumption until you can pay cash than taking out a 401k loan. Avoid 401k loans unless you are truly in dire circumstances or the money is needed for a very short term loan.