5 reasons you should never borrow from your 401(k)

If you work in a corporate environment one of the great benefits you likely have available to you is a 401(k) investment program. These provide a great way to save for your retirement years, especially when your company provides a match for some of your contributions.

One of the features of many of these programs is you have the opportunity to borrow against the money that you have put into your account. There are usually limits as to how much you can borrow and for how long. Payments on your loan are then taken directly out of your paycheck.

My story

Many years ago not long after I had graduated from college, I had a tire blow while I was driving to work one morning. Unfortunately, it happened as I was going around an exit ramp with concrete barriers. I was unable to regain control before I hit the barrier. I was uninjured but my car was totaled. I had bought the car new right after I graduated from college (another dumb idea I can talk about another day), and I still owed more than my insurance company said the car was worth, plus I still needed to get another car.

I had been contributing to my 401(k) with my employer since I had started my job, so I decided to take out a 401(k) loan. I thought I could take a loan for enough to cover the difference between what I owed and what my insurance would pay, plus some extra so that I could purchase a very inexpensive used car for basic transportation until I could get my finances built back up. I didn’t have an emergency fund at the time, so I really didn’t know how else I  could replace my car. Plus, I thought I was making a “wise” financial move since instead of paying interest to a bank, I was paying interest back to me.

So is it “wise” to borrow from your 401(k)?borrow from your 401(k)

I thought I was being wise in choosing to borrow from my 401(k) as opposed to trying to get a loan from a bank. But was that a wise financial decision? In retrospect there are a lot of reasons why it is not a good idea to borrow from your 401(k).

It stops your saving

It depends on the rules of your program, but in most cases you are not able to make new contributions until your loan is paid off.

You are paying yourself interest but…

While it is true that you are paying yourself interest, you are also not earning interest on that balance during the time you are paying the loan off. While I was paying myself 7% interest on the money I had borrowed, had that money still been invested in the market I would have been earning 10%-12% at the time, so I was really losing money each month that went by.

You pay double taxes

One of the major benefits of a 401(k)  is that when you put money in it goes in before taxes, so you can save a little on your tax bill each year. You don’t actually pay taxes on the money until you begin to withdraw it during your retirement years.

It works a little differently though when you are paying back money that you have borrowed from your 401(k). Your loan payments are included in your taxable income. That means on that money you actually end up paying taxes twice: Once when you make your loan payment and again when you withdraw it later in life.

Sign that you have financial problems

If you need to borrow from your 401(k) it is likely a warning sign that your finances are in trouble. In my case, I had made two big mistakes. I bought a new car that I couldn’t afford, and I had no real emergency fund. Those decisions boxed me into a corner where I didn’t have a lot of good options.

The real danger in borrowing from your 401(k)

Those reasons are all sufficient to make the case that it is unwise to borrow from your 401(k), but they are not the most dangerous reason. The worst part of a 401(k) loan is:

If you leave your employer, the loan must be repaid in full within 60 days

If  you should happen to be laid off or fired from your current employer, you must repay that 401(k) loan in full within 60 days. If you do not, then the IRS considers that loan an early withdrawal. That means that you will be charged a 10% penalty plus you will owe taxes on the outstanding balance.  You might need come up with 25% to 50% of your loan balance to pay the IRS. And oh, by the way, that tax bill is coming at a time when you have lost your job and don’t have income coming in. This is a very bad place to find yourself.

Additionally, the rule applies if you leave your employer for any reason. Let’s say you get a call from a friend at another company. They want to hire you for a significant raise over what you are currently making. It’s a great deal and you’d love to go. But you have a 401(k) loan. Same rules will apply. Somehow in that transition you are going to have to find a way to pay off that loan balance, or else you will be looking at a nasty tax bill from the IRS.

Back to my story

In my case I was lucky. Fortunately, the loan I took out was not large. I was able to pay it back in a short time. No doubt I lost some money from an investment standpoint, and given the wonders of compounded interest, I’m sure that amount will not be insignificant by the time I reach retirement age. I was fortunate though that my job then was stable and I was able to pay it off. No one ever explained to me the real potential consequences to taking out that loan.

The bottom-line is unless you have an extreme emergency situation, it is almost never a wise financial move to borrow from your 401(k). As you know if you have read my writings from any length of time, I am not a fan of borrowing money. Borrowing from your 401(k) though is one of the worst ways you can borrow money.

 Photo credit: StockMonkeys.com (creative commons)

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2 thoughts on “5 reasons you should never borrow from your 401(k)

  1. I remember that incident, Bob. I didn’t know of the financial impact though. The idea of borrowing one’s own money from a 401(k) can be seductive, but as you say, it is almost never a good idea.