Common Reasons People Take a 401k Loan
Know the Costs and Risks of Dipping Into Your 401k Before Retirement
If you had to quickly answer the question, "What’s your largest asset?" what would you answer? After their house, most people would say it’s their car. But for many of us—especially if we’re in our 40s or 50s—our 401(k) retirement account is likely worth more than our car.
So, why are we so often reckless with our 401(k) in ways we would never be with an automobile? In other words, why do we borrow from our 401k? Here are some of the most common (and potentially risky) reasons people borrow from their retirement savings, accompanied by reasons you shouldn't borrow from your 401(k).
A House Down Payment
This one seems to make sense on the surface, as you are moving money from one investment to another, assuming home values rise while you own your home. But this really means you have two mortgages—one on the house, and another on your retirement. Worst-case scenario, you might have to sell the house to fund your retirement.
A Child’s Wedding or Lifestyle Upgrades
This is symptomatic of the live-for-today attitude toward money that is common in today's society. It doesn't make much sense to spend $20,000 of your retirement nest egg on a one-day event, new car, or a home remodel. You might make some great memories or enjoy your new cabinets, but the consequences will be considerable and lasting.
You can borrow money to pay for college, but you can’t get a loan to fund your retirement. Work with your budding scholar to figure out some other way to pay for college. While a college education is a great gift to your children, retiring with enough money so that your kids don't have to support you is also a great gift. If you must pay for their college, there are better ways to balance paying for your child's education and saving for retirement.
Consequences of Dipping Into Your 401(k)
Before you dip into your 401(k), understand the real cost and risk of doing so. Withdrawing a significant chunk of cash from your account can set you back in a number of ways.
First, your nest egg is reduced. Second, you are missing out on the compound interest those savings could be earning. This could be a substantial amount of money if you borrow a hefty sum for a couple of years.
Third, some 401(k) plans don’t allow you to contribute until you repay any outstanding loans. This effectively puts your tax-deferred retirement savings strategy on hold.
The IRS has stipulations for 401(k) loans. You should make sure you understand and plan for them.
Finally, if you lose your job while you have an outstanding loan, you will have to repay the entire loan in very short order or possibly face the taxes applied to an early withdrawal, unless you meet certain qualifications. You'll need to meet all of them to avoid the penalties:
- The loan must be a legal agreement, be a secured loan with interest and have a repayment schedule.
- The loan is limited to the lesser amount—50% of the account's balance or $50,000.
- Loan terms should stipulate an ability to make amortized payments at least quarterly.
- A leave of absence exception may be granted, suspending payments for up to a year as long as the repayment period is not changed and the borrower increases payments to meet the repayment schedule.
Only Borrow in an Emergency
Avoid 401(k) loans except in the case of a true and dire emergency. View your automatic contribution to the fund as money that’s gone forever (it will make for a nice surprise when you retire). Establish an emergency fund of six months worth of living expenses to handle unexpected situations. Save up for significant purchases like houses, cars, and weddings. In short, you shouldn't let today’s desires replace the needs of tomorrow.
Internal Revenue Service. "401(k) Plan Fix-It Guide - Participant loans don't conform to the requirements of the plan document and IRC Section 72(p)." Accessed Mar. 23, 2020.