It’s awfully tempting. You see that money in your 401(k) plan account just sitting there.
And you think of all the possible uses for it. Why not take a 401(k) loan? You will pay it back – with interest! Generally, that is a really bad idea. Here are the reasons why.
You will likely forfeit some company matching contributions
Many individuals who borrow from their 401(k) accounts end up stopping or lowering their contributions while they are paying back their loans. This often results in the loss of 401(k) matching contributions when their contribution rates fall below the maximum matched percentage.
There is no better investment you can make than receiving free money in the form of company matching contributions. It is the safest, easiest way to earn 25%, 50% or 100% – depending upon your company’s matching percentage.
Job changes can force defaults
Most individuals considering a job change don’t realize that their outstanding 401(k) loan balance becomes due when they leave their employer. In the case of an involuntary job loss, an outstanding 401(k) loan can add significant pain to an already difficult situation.
Regardless of whether a job change is voluntary or involuntary, few of us have the financial resources available to immediately pay back a 401(k) loan if we leave our employer. As a result, most of us are forced to default.
Studies have shown that 86% of individuals who have an outstanding loan when they leave their employer for a new job will default on that loan. The defaulted balance becomes subject to state and federal taxes and possibly state and federal early withdrawal penalty taxes.
Plan balances that leave 401(k) plans due to loan defaults are rarely restored making it less likely that loan defaulters will build adequate retirement savings.
Studies indicate that participants under 30 who experience a loan default (which is treated as a hardship withdrawal for tax purposes) end up reducing their final retirement balance by an average of 20%. That’s a lot!
The opportunity costs can be substantial
When you take a participant loan, it becomes one of your investments in your 401(k) plan account. Assume that you take a $10,000 loan for five years at a 6% interest rate. That portion of your 401(k) balance will earn a 6% return for five years.
Had your loan balance been invested in one of the other investment options in your plan, you may have earned a lot more. For example, the five-year return on the Schwab S&P 500 Index Fund through September 30, 2018, was nearly 14%. That’s more than twice as much!
Interest on a 401(k) loan is not tax-deductible
Anyone needing a loan should investigate the possibility of taking a home equity loan first, because interest on those loans is tax-deductible.
Although interest deductibility on home equity loans has been limited by tax law changes, you may still be able to deduct interest payments, depending upon the loan’s purpose. It is worth checking.
Paying interest to yourself is not a good idea
I have heard many participants say they believe 401(k) loans make sense because they are paying interest to themselves. They often add that the higher the interest rate, the better!
First, it is normally not a desirable financial strategy to pay interest of any kind. Second, why would you want to pay a higher interest rate on a loan just because you are paying interest to yourself? That just means you have less of a paycheck to live on.
Easy access can lead to bad loans
Can’t get a loan from anywhere else? Yes, you can still get a 401(k) plan loan. There is no underwriting. While this may seem like something that is working in your favor, it actually is not.
Easy access to a 401(k) loan can often make your bad financial situation worse, pushing you into bankruptcy and/or resulting in the loss of your home. If a bank won’t give you a loan because you are falling short on the income requirement, it is probably not a good idea to take a loan from your 401(k) plan.
Your 401(k) plan account balance is protected in the event you declare bankruptcy. Creditors cannot get at your account balance if you need to get a fresh start by declaring bankruptcy. However, if you have an outstanding 401(k) loan, you may end up defaulting on it if you are forced to go through bankruptcy.
Double taxes are paid on interest payments
The interest you pay on any 401(k) loan is double taxed. Since loan payments are made on an after-tax basis, interest on each payroll loan payment is taxed first then and taxed for a second time when paid out to you as a distribution at your retirement.
Many 401(k) plan participants say to me, “Bob, if taking a 401(k) loan is so bad, why would the company let me do it?” Good question! I believe that 401(k) loans should be eliminated as an option from all 401(k) plans.
It is clear that 401(k) loans can drastically reduce your chances of achieving retirement readiness. In addition, they are one of the worst investments you can make in your 401(k) account.
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