Household and consumer debt are on the rise. Student loans are fueling a lot of that lately. Where else might people get a loan? From their retirement plans if the plan permits it. So is borrowing from your 401k a good, or bad, idea?
I suggest that usually it’s a bad idea to borrow from your 401k.
You are NOT borrowing from yourself! You are borrowing from your 401k. What’s the difference? Your 401k has a rate of return … money taken out is NOT earning that return. AND, you’re losing all that compounding growth on the shares within the plan you don’t have.
Many people try to look at the loan as interest free. It is not – there is a calculated interest rate; granted, you are paying that back to your plan. BUT … that interest has already been taxed before you made the repayment … AND gets taxed again when you withdraw the money for retirement income later – thus that interest ends up taxed twice at your ordinary income tax rate.
AND, typically when loans are taken, contributions are stopped! Thus, the compounding growth on those contributions is NOT realized – no extra money, no extra growth. In fact, the money removed for the loan as described above, is added to this doubling loss effect.
If you’ve borrowed from a 401k, and then lose your job (and thus the ability to repay the loan), you must repay the loan – typically within 60 days of leaving the job. If that happens you’ll owe taxes PLUS Federal and State penalties if younger than age 55. Even changing employers requires repayment to your old plan.
If you need some money, simply stopping contributions for a short period of time may be better. At least the money remains in the 401k and gets that growth. Use what you used to contribute to repay a personal loan or low interest credit card. There are no double taxation issues. And there is no risk of tax penalty if you change jobs.
Plus, having to use a personal or credit card loan may make you think twice about why you think you need to borrow in the first place! You see, the perception (myth) that you are borrowing from, and repaying, yourself may actually encourage borrowing you may not really consider doing under other frames of mind. And it is on this point that I think borrowing from 401k’s is not a good idea. Having a reserves account is better and keeps your standard of living within a sustainable range in the long run; a standard of living that you may be more likely sustaining into and through retirement too.