Why You Should Not Borrow
From Your 401-k
Most companies, at least the larger ones, offer 401k programs. One of the perceived benefits of having a 401k is the ability to borrow money from it. On the surface this seems like a great idea. You get to take out a loan against your own money, and pay yourself the interest (generally prime + 1%). It also doesn’t show up on your credit score.
There are some significant downsides to 401k loans:
1 - You are borrowing against your future
With a 401k loan, you are borrowing money from your retirement account at, let’s say 7%. What you have to consider though is that you are giving up on average a 12% or so return, which is a difference of 5%. Over the long haul, this can have a significant impact on your final 401k balance when you decide to retire.
2 - If you leave your job voluntarily or not, the full amount is due immediately
One thing many people don’t realize is that if for some reason you want or need to leave your job or worst case you get laid off the full amount of the loan is generally due in 30-60 days.
3 - If you can’t pay the loan back, the unpaid balance is treated like distribution
If for some reason you can’t pay back the balance, the unpaid balance is treated like a distribution. In other words in addition to income taxes you would need to pay on the money, you also have to pay a 10% penalty. This can obviously be a considerable amount of money.
4 - You pay double taxes
While the loan itself isn’t taxed, remember you are paying the loan from payroll taxed dollars. Down the road when you pull out of your 401k, you will again have to pay taxes on that as well, so essentially any money you pay against the loan is really double taxed.
5 - Starts a bad habit
In general borrowing from your 401k can start a bad habit. Most financial advisers will agree that borrowing from your 401k is risky and hurts your overall 401k value. Once you do this, you are more likely to continue doing it, and possibly using it to buy crazy stuff you really don’t need. It just starts a bad trend, and one that you should really avoid. Remember, you are borrowing off your retirement, your future.
6 - Some plans make you stop contributing while your loan is outstanding
Some company plans force you to stop contributing while your loan is outstanding. This can turn out to be considerable dollars lost, in particular on a longer term loan like the maximum 5 years.
Also, in order to be able to make the 401k loan payments, many people voluntarily stop contributing, or reduce their contributions to be able to pay the loan. Again, considerable dollars lost over the course of the loan.
7 - Some plans charge a fee for loans
Some company plans charge fees for the loan, and depending on the fees, this may make an already bad option even worse.
Most 401k plans offer mutual funds as the primary investment tools. Mutual funds are a long term investment, and most financial experts recommend keeping your money in them for more than 10 years at the minimum. Mutual funds consist of company stocks, and based on the market the values of the fund over any one period will be high and low depending on how the market is doing. Right now, the market is down, and thus most everyone’s investments, mutual funds, and 401ks are taking a beating.
The good news is that over the history of the market, stocks and thus mutual funds return on average 10-15%. In order to receive the benefits you have to hang in there and keep putting your money in even when the market is down.
Another point is as you contribute money, you are buying new funds. When the market is down, you are buying those funds at a lower price and when the market does go back up you will earn more. Remember: buy low, sell high.
When you take an early withdrawal of your 401k money, there is a mandatory IRS early withdrawal penalty of 10%. Additionally, your 401k money will be treated as taxable income. 20% will automatically be pulled out, and the remainder will is required to be listed as income when you file your federal and state income taxes. Depending on the amount in your 401k, this can be a considerable some of money and can cause you to have to pay a larger than expected amount of income tax.
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