So, you are thinking of borrowing money from your 401(k). Is this a good idea? On one hand, it could be less expensive to borrow from your 401(k) because the interest rate is typically lower than what a bank or credit card might charge you for a loan. It would also seem that since you are borrowing from yourself, you are paying yourself back—so what is the harm?
Even with these facts, it is something you should give thought to before acting on. Here is why:
1. You lose the tax advantage.
Your 401(k) is often funded with pre-tax dollars coming directly out of your paycheck. This is a big incentive to participate in this type of a retirement plan, as it can lessen your taxable income for the year and provide tax-deferred growth, leading to greater compound growth over time compared with a taxable account.
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However, when you repay a 401(k) loan, you are paying it back with money that has already been taxed. You will then pay taxes again when the money is eventually withdrawn from the account, which means you will pay taxes on that money twice—effectively wiping out one of the best incentives of the plan.
2. You are no longer making money.
Since the money you borrow is no longer being invested, you will miss out on any potential growth of those dollars for the duration of your loan. The low interest rate you are paying on this loan may not compare to the market appreciation that you are missing. Even more than market appreciation, the compound effect of growth over time will be reduced as a result of having a lesser account balance invested.
Additionally, many plans won't allow you to contribute to your 401(k) until the loan is paid off. This can mean the loss of a tax deduction for as long as your loan is outstanding.
3. You could become trapped.
Most plans require that the loan be repaid within 60 to 90 days if you quit your job. This can keep you tied to your job, forcing you to pass on better opportunities that may come your way. If you are unable or unwilling to pay within the time allotted in your plan, the full amount will be treated like a distribution, subject to income tax and a 10% early-withdrawal penalty if you under the age of 59½. This can create significant additional financial strain on an already stressful life event, and also wipes out the potential for repaying yourself, capping future savings to annual contribution limits.
4. Your salary will decrease.
The repayment of your loan may come directly from your paycheck, which could reduce your take-home pay significantly. By repaying with after-tax dollars and potentially losing a tax-deductible contribution for the year, your taxes could increase and lower your net pay even further.
5. That is not its purpose.
A 401(k) exists so you can save for retirement. If you start borrowing from this account, it may lead to your retirement being inadequately funded. So, no matter how urgent your current situation may appear, it may be nothing compared with what you could face without sufficient funds in your 70s or 80s.
Re-Evaluate Your Lifestyle
The need to borrow from your 401(k) could be a warning that you are living beyond your means. When you can't find any way to fund your lifestyle other than by taking money from your future, it may be time for a serious re-evaluation of your spending habits.
Unfortunately, many people view their 401(k) retirement fund as an easy way to borrow for short-term financing needs, but as you can see from the reasons outlined, it is typically a good idea to avoid borrowing from your 401(k) or workplace retirement plan. Putting your short-term needs ahead of your long-term goals is a quick way to set back your retirement savings. The bottom line: pay yourself first and think long and hard before treating your retirement savings like a piggy bank.
Christopher Scalese, financial adviser, insurance professional and the president of Fortune Financial Group, focuses on assisting in the financial transition from working to retirement years.
Steve Post contributed to this article.
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