401k Loans Are a Bad Deal
If you work for an employer that offers a 401k retirement plan, you may, at some point in your life, be tempted to borrow from that plan. Not all 401k plans offer a loan option, but if yours does, here are some points to consider before you decide to make yourself a loan.
For starters, you really are borrowing from yourself. You put the money in originally, and it’s still yours when you take it out as a loan. Instead of the money working for you by earning interest and/or growing in value, loan money misses out by being in your pocket instead. It may not seem like you’re losing much now by taking some of your retirement money out, but you’d be surprised what a difference that “lost” money can make over time. Maybe the only good thing about a 401k loan is that you have to repay it within five years in most cases. But even missing five years of earnings can make a big difference later in your retirement years.
Probably the biggest problem with 401k loans that nearly everyone avoids mentioning is taxes. Money going into your 401k is pre-tax, meaning you don’t pay any taxes on your contributions. Normally you pay taxes when you take your money out in retirement. Our government’s general rule on income is to only tax you once.
But you get a double-whammy with 401k loans. After you borrow from your plan, you repay your loan with after-tax dollars. So you’ll pay taxes on that income once during your working years. Your loan money goes back into your 401k plan, and let’s say you leave it there until you retire. What happens when you start taking your money out of your 401k plan in retirement? It all gets taxed—even your loan dollars. So your loan money actually winds up paying taxes twice! That suddenly makes a 401k loan a very expensive borrowing option. Most people will be better off, after taxes and those lost earnings I mentioned earlier, just borrowing from a bank or credit union.
By the way, if you default on re-paying your 401k loan, the IRS simply treats you like you took all the loan money out of your plan before retirement. That means taxes will be due and you’ll likely pay an early 10% withdrawal penalty as well. That’s one time borrowing from yourself can be very expensive.