How 401(k) Loans Can Threaten Your Long-Term Financial Security
Did you know that many 401(k) plans allow participants to borrow up to 50% of their vested account balance (up to $50,000) for five years and pay it back a low interest rate that goes right back into the account? Sounds like a great deal, right? After all, you won’t be needing those retirement assets for many years, plus you reap the benefit of the additional interest you’re putting back into the retirement account. Not so fast! There are several important reasons why taking a loan from your 401(k) is a bad idea.
#1 – Taking a loan from your 401(k) comes with significant tax consequences.
Wait a minute…aren’t 401(k) loans tax-free? While they’re tax-free at the time they’re taken, they’ll end up costing you in the long run.
Remember that your 401(k) deferrals are made with pre-tax dollars, while your loan repayments are made with after-tax dollars. That means your repayment amount will end up being more than your original contributions. For example, if you fall into the 24% tax bracket, every dollar you earn to pay back your loan is only worth $0.76 after taxes. In order to make your account whole again, you’ll end up paying 24% more than what you borrowed (not including interest).
In addition, you don’t get credit for having paid taxes on the loan repayment amount. Because the funds are going back to repay a pre-tax savings source, your after-tax loan repayments are earmarked as pre-tax money. When you withdraw those assets from your account in retirement, they’re considered pre-tax funds and are taxed as ordinary income. Put simply, you’ll end up paying taxes twice on the amount used to repay your 401(k) loan. That’s a hefty consequence!
#2 – You’ll be missing out on growth opportunities.
When you take a loan from your 401(k), you’re taking money out of the market. By doing so, you lose out on both the potential for market growth and the benefits of compounding interest. Consider the following chart, which illustrates how missing just a few days in the market over many years can greatly impact a portfolio’s performance.
If you take a five-year loan from your 401(k), you’re missing out on a lot of opportunity to grow your assets, which can be difficult to recover from.
#3 – You may need to pay back the loan at the most inopportune time.
Most 401(k) plans require you to pay off your loan balance in full within 90 days of leaving the company you worked at when the loan was initiated. If you don’t pay back the loan within that timeframe, your outstanding loan balance will be taxed as ordinary income, and you may be subject to an additional 10% early withdrawal penalty if you have not yet reached age 59 ½.
If you’re unexpectedly let go from your job and don’t have another job lined up, your outstanding loan balance could put you in a tough situation. On the other hand, if something happens with your job that makes you want to leave your current employer, it may be difficult to do so given the financial responsibility of your outstanding loan.
#4 – You may miss out on the benefit of pre-tax deferrals and employer matching funds.
Some 401(k) plans don’t allow participants with an outstanding loan balance to make additional contributions until the balance is paid off. That’s a triple-edged sword. Not only are you missing out on the benefit of regular contributions but you may also miss out on the associated company match and your taxable income will increase without the benefit of pre-tax deferrals.
Also, referring back to #2 above, a freeze in contributions can mean missed opportunities for both market growth and compounding interest. That’s a big hit to your long-term financial security.
Put simply, borrowing from your 401(k) is not a good idea and can negatively impact your financial health long into the future. If you’re in need of extra cash to finance a big purchase or fund your lifestyle, there may be better solutions than borrowing from your 401(k).
At Creative Planning, we help our clients navigate a wide range of financial challenges, including the decision of whether to borrow from their 401(k). If you’d like help planning for your financial future, please schedule a call. We look forward to getting to know you!
