Ideally, never… or at least rarely. Looting our retirement piggy banks can be tempting when a financial emergency arises or perhaps when we are looking for money to finance the purchase of a home or to pay off some high interest credit cards. Even if IRS Rules Authorize Retirement Plan Loans, the maximum loan size is either (1) half of your 401 (k) vested balance or (2) $ 50,000, whichever is less. While borrowing from yourself in this way can be convenient and seem relatively harmless, this type of short-term fix can have long-term consequences that are more costly than we realize.
401 (k) loans look attractive … at first glance. On the one hand, borrowing from our company pension plans is tempting for several reasons:
- No credit check is required and therefore it will not affect your credit score.
- The interest rate is potentially lower than that of a traditional loan.
- You easily repay the loan through payroll deduction.
- You borrow your own money and pay yourself back with interest. Where’s the harm, right?
Then things can go wrong. A closer look at how exactly all the moving parts work as well as some of the things that could potentially go wrong could lead you to conclude that getting a bank loan, borrowing against home equity, selling other assets. or even borrowing from the family might be better for you in the long run. Here are some of the reasons to think twice before taking out a 401 (k) loan:
You will pay taxes twice on the same money. It’s true that you pay yourself back with interest, but you also use after-tax dollars to make those interest payments. Going forward, when you spend your pre-tax 401 (k) money in retirement, those future interest distributions will be taxable as ordinary income, meaning that you will actually pay tax twice on that money.
Growth loss and composition. The money you borrow from your 401 (k) is temporarily withdrawn from the underlying investments, thus missing out on any market growth, interest, dividends, etc. The double whammy comes from the missed opportunity to reinvest that growth and earn even more through capitalization, which is the financial superpower that comes from investing – and stay invested in time.
Treat your 401 (k) like an ATM. Once you’ve tapped into your retirement plan and used it to relieve some type of financial pain, you can start to slide down a slippery slope in financial behavior. After rewarding yourself once with a relatively easy source of money, you run the risk of training your brain to think of this strategy as a reasonable substitute for creating and maintaining better financial habits, such as regularly saving money in an emergency fund, stick to a budget or increase your contribution rate to a pension plan. Staying true to better health financial priorities helps you avoid disrupting the progress of your retirement plan by treating it like an ATM and tapping into it multiple times.
Less net salary. While you are repaying your loan, your salary will be reduced by the loan repayment amount. If your cash flow was tight before plundering your retirement fund, you may soon find that it becomes even more difficult with a reduced salary.
Severe taxes and penalties. If you quit your employer for some reason – whether it’s your idea or your employer fires you – you may need to pay off the entire remaining loan balance within 60 to 90 days. This requirement varies from plan to plan. Some company pension plans allow you to continue making scheduled loan repayments without having to prepay everything.
However, your payments will obviously no longer come from payroll deductions after your employment ends. If your unemployment spell is long, you may not be able to meet the required repayment schedule. Once you default on a 401 (k) loan, the IRS then treats any remaining balance as a taxable distribution. If you are under 59 and a half at this time, there may be a 10% additional tax penalty to take an early withdrawal from your pension plan. What was once a temporary financial fix could quickly turn into a costly tax bomb.
It might be good to borrow once, if:
You have high interest rate debt (think double digits) and you’ve exhausted all other opportunities to refinance or negotiate a lower interest rate. The ongoing challenge will be to reduce any temptation to start using the same credit cards or high interest loan sources again and recreate the problem. Once you’ve paid off the 401 (k) loan, take that monthly loan payment you were making and redirect it to a savings account at your bank, building up an emergency fund that you can use for future ones. financial emergencies, rather than pillaging your retirement plan like a hacker.
You owe the back taxes to the IRS. With interest and penalties accumulating on overdue taxes, this financial burden can become very serious over time. In that case, a 401 (k) loan could be your saving grace. However, you may qualify for relief under IRS guidelines for alternative payment plans and difficulties
You are in real danger of defaulting on a student loan. In most cases, bankruptcy is not an option for them.
You are facing impending bankruptcy or an eviction from your home. Talk to a nonprofit consumer credit counselor (nfcc.org) on alternatives to bankruptcy. If a 401 (k) loan can save you valuable time as you restructure your cash flow and other investments to support a sustainable strategy and pay off your 401 (k) loan, it might be an appropriate financial decision.
The important thing to keep in mind about lending in your retirement plan is to make sure you meet the underlying need for cash rather than just assuming that the 401 (k) loan will solve the immediate problem. Otherwise, you could find yourself on an unhealthy financial treadmill where you repeatedly borrow from your 401 (k) and start to seriously compromise your ability to retire on time, comfortably, or both. A good way to see how damaging and costly a retirement plan loan can be for your financial future is to use the National Policy Analysis Center (NCPA) 401 (k) loan calculator. This calculator shows how much money you might have less for retirement if you borrow from your retirement plan versus not taking out a 401 (k) loan. Bottom line: Make sure you’ve carefully considered all other alternatives before you undo much of the hard work you’ve already put into growing your retirement nest egg.