If you have unexpected expenses such as a hefty tax bill or an expensive home repair, you may be thinking about borrowing from your 401(k) plan.    

“Think again,” says Robert DiQuollo, CFP®, CPA, president of Brinton Eaton, a wealth manager in Madison, NJ. “Although your 401(k) may appear to be an easy source of funds, it’s a terrible idea to tap it unless you have nowhere else to turn.” 

A common misconception is that a 401(k) is akin to a savings account from which you can draw at will, with seemingly limited consequences.  Advantages of borrowing from a 401(k) include a low interest rate, no credit check, and the fact that you pay interest to yourself, rather than to a bank or credit card company. 

Most 401(k) plans allow—but are not required—to permit loans.  You need to check your plan documents.  Also take note that the IRS allows you to borrow no more than 50% of your account value, up to a maximum of $50,000. 

But there’s a much bigger downside.  The loss of tax-deferred savings for retirement is a key disadvantage—and one of the best arguments for not borrowing from your 401(k).  

“The loan may have cost little in terms of its interest rate and accessibility, but in reality, you are depriving yourself of the ability to save for your retirement—tax-deferred—which could add up to a tidy sum over time,” DiQuollo says. 

This is because some employers prohibit ongoing contributions to the plan until the loan is completely repaid. Therefore, besides the loss of investment income that would have been generated on the amount of the loan, you are precluded from further pre-tax savings—plus, you will lose the company match on the prohibited contributions—making your retirement nest egg a three-time loser. 

Additionally, loans are paid back with after-tax monies, not pre-tax like your original contribution.  

Borrower Beware:  Potential IRS Penalties and More 

Payback provisions could also cost you more than lost investment income and savings. 

If you lose or leave your job, most plans require full loan repayment within 60 days, a tall order in many cases, DiQuollo points out.  If you are unable to pay within this timeframe, the loan is considered in default, at which time the Internal Revenue Service re-categorizes the loan as a distribution.  If you haven’t reached the age of 59 ½, you are generally subject to an additional 10% early withdrawal penalty.  Your “distribution” must now also be included as taxable income on your tax return.  

Don’t shortchange your financial security by borrowing from your retirement plan.  

“The missed contributions and growth opportunities are very difficult to recoup, and the eventual loss of retirement income could force you to work longer than you would like,” DiQuollo says.  “Consider your personal financial situation and weigh the pros and cons carefully before making any decisions.  Your financial advisor can provide valuable counsel.” 

A home equity loan may be a better option, he adds, especially if you’ve owned your home for several years and have built up enough equity to qualify.  Usually the payments on the home equity loan are less than the 401(k) payments (due to the difference in repayment periods), the interest is tax deductible and, should your life circumstances suddenly change, you do not incur a taxable event.  

Media Contact:

Patty Buchanan

FastLane

(973) 670-1203

pbuchanan@fast-lane.net