It’s tempting. The money is sitting in an account you may not touch for years or even decades. Why not put it to work now to buy a home, renovate, or pay down debt? You’re paying yourself back with interest anyway. Outside of a true emergency, though, a loan from your 401(k) is usually not worth it. Here are five things to consider before borrowing.
1. Your retirement could suffer a setback
The years you spend repaying the loan could be spent building your retirement savings instead. The money you borrow also misses out on any market growth while it’s out of the account. Over long periods, that lost compounding can be a large opportunity cost.
2. You could miss out on an employer match
Part of your monthly budget for retirement now goes toward repaying the loan. If you cut back on your regular contributions to afford the payments, you could also miss out on your employer’s matching contribution, which is free money.
3. Pre-tax money gets repaid with after-tax dollars
You may have contributed with pre-tax dollars, but you repay the loan with after-tax dollars. When you retire, your withdrawals will be taxed again, even though you put the money back with dollars you already paid tax on. In effect, you pay tax twice on the loan amount.
4. What if you can’t pay it back?
If you don’t repay the loan within the required period, usually five years, the unpaid balance is treated as a distribution. It becomes taxable, and if you are under age 59½ you may also owe a 10% penalty.
5. If you leave your job, the loan can come due quickly
If you leave your job, even if you are let go, most plans require the outstanding balance to be repaid. If it isn’t, the plan offsets the balance against your account and it is treated as a distribution, which means taxes and potentially a penalty.
There is one important safety valve. When a loan is offset because you left your job or the plan ended, you have until your tax filing deadline for that year, including extensions, to roll that amount into an IRA or another plan and avoid the tax. That is much longer than the usual 60-day rollover window, but it still requires you to come up with the cash, often at an inconvenient time.
Before you borrow
Pensions are far less common than they used to be, so your own savings will likely need to cover much of your retirement. If you still decide a loan is right for you, ask your plan administrator about fees and repayment terms, and have a plan for what happens if you change jobs. For more on building an emergency cushion so you don’t need to borrow, see Smart Financial Strategies for Unexpected Events. If you are unsure, reach out and I can help you make this decision.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
