WHEN BORROWING, STEER CLEAR OF 401(k)

Borrowing from your 401(k) account may seem like an easy answer to cover the cost of vacation, holidays, or a financial emergency.  However, using the funds in your 401(k) to cover these costs now may mean the cost of your retirement is not covered down the road.  

Although, there can be advantages to borrowing against your 401(k) such as no credit check and you’re paying yourself interest.  But, before you make the decision to take a loan from your 401(k), be aware that there are many disadvantages also.

First, since you would be removing those dollars from the market, you would not be eligible for any gains or dividends that may have been earned on the investments.   Second, even though you are paying the interest back to yourself, if the rate of interest is less than the rate of return that your funds would have earned if invested, you’re losing money.  Third, unlike a home equity loan, the interest you pay is not tax deductible. 

In addition, if you leave your employer you must repay the outstanding loan balance or it’s defaulted and considered taxable income for the year.  In this case, the 10% early withdrawal penalty would apply.  If you lose your job unexpectedly and can’t afford to pay the loan back, you could be in an even more difficult situation at tax time than the one that prompted you to take the loan to begin with.   Assume that you borrowed $20,000 and were in a 25% tax bracket, 35% of the loan amount would be lost to the IRS and your $20,000 becomes $13,000.

The bottom line is that your 401(k) account is a long term investment meant for retirement.  It is not a savings account, and borrowing against it should not be taken lightly.  If you are facing a financial emergency and a loan against your 401(k) is your only option, you should borrow as little as possible for the shortest time frame you can manage.

THE COST OF BORROWING FROM YOUR 401(k) 

Making the decision to borrow against your 401(k) may cost you more then you think.   In addition to fees and interest, the biggest expense is the lost opportunity for the money to gain value if it was left invested instead.  The interest that your money earns while it is invested is compounded, meaning that the original interest is added to your balance.   A larger balance can compound faster than a smaller one. Since taking a loan results in a smaller balance, this can have a dramatic effect on your balance at retirement.

Another thing to consider is how the payment may affect your ability to make contributions to your 401(k).  If you have to stop or lower your contributions because you cannot afford them while making loan payments, consider how the change will affect your retirement goals.

Here’s an example scenario on the impact of a 401(k) loan:

In the next scenario:

• You are 35 years of age

•  You have a balance of $20,000

•  You borrow $10,000 from your account at a 7% interest rate for 5 years

•  You lower your contributions to $50 per paycheck to afford the loan payments

• At age 65, your balance is $194,614 less than the balance would have been, had you never taken a loan and left your contributions at $150 per pay

When you take money out of your 401(k) you are not borrowing from a bank.  You are taking the money out of your own account and using money from your paycheck to repay it.  The money that is outstanding from your 401(k) loses the opportunity to earn compounded interest.  The long term effect could be that you end up working longer than you had planned. 

These repayments are also made on an “after-tax” basis.  For example, at a 30% tax bracket, you must earn $71 to have $50 left after taxes to make your loan payment.