Avoid These Pitfalls of Taking out a 401k Loan

Posted by Don on May 3, 2016

A popular way to borrow money recently has been to take a loan from your 401k plan. The thought is this type of loan is OK since you are both the borrower and lender and therefore, you reap the rewards of the interest. While technically this is true, there are some pitfalls to avoid when taking out a 401k loan and some issues to consider before you sign on the dotted line. Let’s review them so you can make the best decision for you and your future.

401k loan

(Photo Credit: Stuart Miles/FreeDigitalPhotos.net)

How Does a 401k Loan Work?

Here is a brief background for how a 401k loan works. You fill out the necessary paperwork with your employer and you get a check for the loan amount. You then repay the loan back to your 401k plan along with a stated interest rate. For most loans from a 401k plan, the interest rate is usually 1-2% higher than the prime rate.

As of this writing the prime rate is 3.5% so you would be looking at an interest rate of 4.5% or 5.5% if you took out a loan today. Again, you pay yourself the interest.

Other things to consider:

  • The loan must be repaid in 5 years but can be longer if the money is used for the purchase of a new home
  • You can borrow up to 50% of your 401k plan balance or a maximum of $50,000
  • In many cases, you have to pay fees to take out this loan
  • You cannot change the monthly amount you have to repay
  • The interest you pay is not tax deductible

The Pitfalls of 401k Loans

On the surface, this sounds like a win-win situation. You borrow money and pay yourself and not some greedy bank the interest. But here are a few things you need to understand.

You Decide to Quit

Let’s say you take out a 401k loan and 6 months later you find your dream job. What happens to your loan? It is due in full within 30 or 60 days (depends on your 401k plan guidelines) of you leaving your employer. So, if you took out a $25,000 loan, and there is a $22,000 balance outstanding, you have to pay this $22,000 in full in 60 days. Odds are you don’t have $22,000 lying around otherwise you wouldn’t have needed the loan.

So what happens? The IRS makes you pay taxes on the amount outstanding plus an early withdrawal penalty (the penalty only applies if you are under 59 ½ years old).

The penalty is 10%. So, if you are in the 25% tax bracket and you have the $22,000 outstanding balance, you would owe $7,700 ($22,000 x 0.25) + ($22,000 x .10) in taxes. That’s not fun.

You Hurt Your Future Self: Stopping Contributions

Most people don’t save enough for retirement to begin with. When you take money from your 401k plan, you increase the risk of waking up when you are 60 and realizing you can never retire.

Yes you will pay yourself back the money (hopefully you will, but there is a chance you won’t) but as life happens and expenses arise, you may cut back or stop your retirement savings.

Additionally, many people stop their regular contributions to the plan when they have a loan to repay. The thinking is that since you are paying yourself, you aren’t negatively hurting yourself. But doing this will hurt you greatly as we will see in the point below.

Ideally you just want to leave retirement money be. It is for retirement after all and was never intended to be a short term loan.

You Hurt Your Future Self: Missing Stock Market Growth

Paying yourself sounds great, but you are really hurting your retirement dreams. This is because of compound interest. If you were to leave the money alone to grow in the stock market, it would most likely average 8% annually (the historical average of the stock market).

By taking the loan, you are at best paying yourself 5.5% interest. That is a difference of 2.5%. I know it doesn’t sound like much, but thanks to compound interest, it is.

Let’s look at a quick example. You have $50,000 saved for retirement and that money will grow for 30 years. In scenario 1, you leave the money invested in the stock market and never add any more to it. In scenario 2, you take a $25,000 loan out and pay back with 5.5% interest. What do you end up with in 30 years?

  • Scenario 1 (left money invested): $503,132
  • Scenario 2 (took the loan): $470,432

That 2.5% difference in interest turns out to be a costly one. You have $30,000 less because you took out that loan.

The kicker here is that it is a simplified example. Most likely you are adding more money each month to your retirement plan so the difference is going to be much greater.

Final Thoughts

You need to really think long and hard before taking out a 401k loan. It sounds great – you pay yourself back the interest, but you earn a lower return and that lower return can cost you in the future.

I’m not saying you should never consider taking out this type of loan, but rather make it a second or third option. In many cases, people use this loan when buying a house. They need the cash for a down payment.

Try to find ways to save money for the down payment as opposed to raiding your retirement account. It’s not the end of the world if you have to put off the dream of home ownership a year or two so you can save for a down payment.

Taking on a house purchase is a big step and it has lots of unexpected expenses related to it. Make sure you are on solid financial ground, which includes a healthy retirement balance so you don’t jeopardize your future dreams.

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