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Grow Your Business Finances

Why You Shouldn't Borrow From Your 401(k)

Why You Shouldn't Borrow from Your 401(k)
Credit: ShutterstockProfessional

Ask most financial advisors about borrowing from your 401(k), and their response will be brief and blunt: "Don't do it."

Those three words sum up the prevailing sentiment on the subject. Still, the dire warnings don't scare everyone from tapping into their nest egg.

According to Forbes, roughly 40 percent of individuals with a 401(k) borrow against their plans at some point. If you're considering taking out a loan against your plan, know the basics first.

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That answer depends on your employer's plan. Employers are not required to allow loans against retirement savings. Some plans don't while some allow multiple loans. Most, though, have a minimum amount you are allowed to draw from your 401(k). Check with your plan administrator or read your summary plan description to know if a minimum applies, and, if so, what that amount is.

Minimum loan amounts vary, but the maximum is $50,000, or 50 percent of your vested balance, whichever is less. Vesting rules vary also, so check with your plan's administrator.

Opportunity costs aside (we'll get there in a minute), the interest rates on 401(k) loans can be very attractive compared to other borrowing options – just 1 percent over the prime rate in many cases. [Interested in setting up retirement options for your employees? Check out the best employee retirement plans of 2019.]

Typically one to five years, unless the loan is for the purchase of a primary residence. A repayment schedule will be part of the loan agreement. For details, check your plan.

Because they believe in the value of saving for retirement, and they don't want you to fall off track. Here are the biggest reasons for keeping your hands off that nest egg:

  • Your earning potential takes a big hit. Missed growth opportunities is the primary and most obvious reason to avoid borrowing from your 401(k). Recent market volatility aside, over time, your managed investments will grow. The more dollars you have working for you, the more you can make. Pulling money out reduces your earning potential. The closer you are to retirement, the harder it is to catch up.
     
  • For the duration of your loan, you can't contribute to your 401(k). According to Charisse Mackenzie, a financial advisor and president of Saturn Wealth, most people who borrow from their 401(k) stop contributing to their plan while the loan is outstanding. In fact, many plans rule out contributions for the duration of the loan. Since your employer can't match what you don't contribute, that free money you'd be getting in matching funds dries up too. That's a double whammy that you may come to regret in the future.
     
  • When you do have to repay the loan, your take-home pay is reduced. Eventually, you have to repay yourself. Most loan terms range from one to five years, and payments come from payroll deductions using after-tax dollars. This decreases your take-home pay to less than what it was before you needed the cash.
     
  • You're locked into your job during the duration of the loan. Changing or losing your job means you'll have to repay the debt. While it's true the Tax Cuts and Jobs Act of 2017 gave job-changers more time to come up with the funds, it didn't remove the requirement to repay the loan. Regardless of your plan's wording, you have until the deadline for filing your income taxes to get that money into an IRA. If you miss the deadline, the outstanding loan amount will be considered a distribution, and you're liable not only for the taxes, but you'll pay a 10 percent early withdrawal penalty (assuming you're under 59 1/2). This is called default, and according to Forbes, it happens to 10 percent of people who take out 401(k) loans.

Real emergencies happen, and, sometimes, dipping into your retirement savings is the least of all possible evils. Charisse Mackenzie points out three reasons a 401(k) loan might be your best option.

The low interest rate could be better than anything else available. There's typically a quick turnaround time to obtaining a loan, and, in an emergency, that can be key. Finally, and this could be the big one, there's no credit check. Since borrowing from oneself is not a loan in the traditional sense, it is not reported to credit bureaus.

In the end, the decision is yours. Weigh your needs, check your other options, and make sure you understand the terms of your plan. If you take out a loan, have a plan to repay your future self as quickly as possible and get back in the savings game.

Joyce Walsack

Joyce Walsack has spent her career working at small businesses and knows the many challenges business owners face. She lives in the Adirondacks Mountain in upstate New York where, when she’s not shoveling snow, she writes young adult fiction, enjoys boating on Lake George and hiking in the woods.