We all know that the purpose of a 401(k) is to save and grow money for retirement.
But when a general need for cash or life’s unexpected emergencies come up, all that money is just sitting there, unused and tempting. Most 401k plans allow you to take a loan up to 50% of the account balance, or $50,000—whichever is less—and most loans give you up to five years to repay. (For those borrowing from a 401k plan to buy their first home, there is usually a longer repayment period.) What would be the harm in using it when you need it?
The Consequences of Taking out a 401(k) Loan
Remember, the point of a 401(k) is to save and grow your money for retirement. Taking away from that fund directly impacts your future. Some plans don’t allow further contributions until your loan is paid off, and that big chunk of money won’t enjoy compounded interest, affecting how much you’ll end up with when you retire.
If you are unable to pay back the loan in the required repayment period, things will become particularly expensive for you. The money will then be considered an early distribution of your retirement account if you are under the age of 59 ½, which means it is subject to regular income taxes as well as a 10% penalty. A large, unexpected tax bill will only further complicate whatever financial problems drove you to take the loan out in the first place.
If You Leave Your Job Before the Loan Is Paid Off
The worst thing that can happen when you have taken a loan from your 401(k) is to suddenly have to pay the entire loan back in 60 to 90 days. That is what you’ll need to do if you leave your job before the loan is paid off, whether you leave for another job or you are let go. Imagine the terror of being required to pay, say, $30,000 back in two or three months when you’ve just lost your only source of income. That’s a tall order no matter how generously-compensated a lawyer you are. If you take a 401(k) loan, you are stuck in your job until that loan is paid off—and you’ll need to keep your fingers crossed that there are no lay-offs on the horizon.
Long-Reaching Tax Ramifications
Just in case the point hasn’t been hammered home well enough, the tax consequences of taking a loan from your 401(k) are substantial. Even if you do everything the right way—you pay it all back in time and you don’t lose your job—you will lose a significant amount of money by being double taxed. Here’s how that works: When you repay the money from the loan, you use after-tax dollars (your individual contributions are with pre-tax money). Once you retire and begin taking the money out of your account, you will, of course, pay taxes on it. No distinction is made between the pre-tax contributions you made to the account and the after-tax loan repayments. So you end up paying taxes twice: once when the money goes in and once when it comes out. That will end up costing you thousands. On top of that, interest on a 401(k) loan isn’t tax deductible, so if you’re borrowing money to buy a house or you’re using 401(k) money to repay student loans, you’re not getting the mortgage interest deduction or tax deduction for student loan interest that you would almost certainly be entitled to.
Ultimately, it’s understandable that if your financial situation begins to go downhill, you might look at this account full of thousands of dollars and think “Why not? I can just pay this back.” But unless your life literally depends on taking that money out, avoid it if you can get out of your negative financial position any other way.