Learn the Pros and Cons of Borrowing From Your 401(k)
Taking a Loan Could Mean Double Taxation on the Interest
There are pros and cons to taking a loan from your 401(k) plan. You can only borrow from your plan if you are currently employed by the company that offers the plan, and even then, not all company plans allow loans. So, you’ll need to check the rules on your plan to see if loans are allowed by reading your documents or talking with your Human Resources or plan representative. If you are eligible to borrow money from your 401(k) plan consider the pros and cons before you decide to take the loan.
- No loan application necessary.
- No minimum credit score required.
- You repay the loan with automatic paycheck deductions over a maximum term of up to five years.
- Double taxation on the interest component. You are now paying interest back into your 401(k) plan with after-tax money. If you hadn’t borrowed the money, it would be earning tax-deferred interest inside of the plan and it would only be taxed once - when you withdraw it. By borrowing it out, you now have to earn the money, pay taxes on it, then put the interest back into the plan. When you withdraw it later, you'll pay income tax on it again. This defeats the purpose of having a tax-deferred account.
- If you leave your employer before the loan is repaid, any outstanding balance may be treated as a taxable distribution to you unless entirely repaid within a specific amount of time.
- 401(k) money is protected from creditors and bankruptcy. If you borrow funds from the plan to pay debts, and remain in financial trouble and end up filing bankruptcy, you will have used money to pay debts, when in fact this money would have been protected for your retirement.
Reasons People Borrow Take 401(k) Loans
People borrow money from their 401(k) for the following reasons. I do not think they are good reasons:
- To fund a business start-up.
- To help a grown child.
- To buy a car.
- To pay off other debt.
For the most part, I think borrowing money from your 401(k) plan for these items is a bad idea.
You are hurting your future retirement savings. Think about the 70 or 80 year old you... and think twice before you use up their nest egg.
Who Should Borrow Money From Their 401(K) Plan?
Since 401(k) plan money is protected from creditors, you want to think very carefully before you borrow it out and void that protection. You should explore all other options before deciding on a 401(k) loan.
If you manage money well, and feel your job is secure, a 401(k) loan might be an acceptable option for you. I have seen a CPA repeatedly borrow and repay money from his 401(k) plan to help fund the acquisition of other businesses. This worked well for him. He understood the repayment clause, followed all the rules and best of all, always put the money back into his plan on time.
Who Should Not Borrow Money From Their 401(K) Plan?
If you have debt, borrowing from your 401(k) plan to pay it off might be the worst possible solution. Why?
Because if you do not get your finances in order and your debt troubles continue you are not really better off. Reason being, if you leave the money in your 401(k) plan it is protected from creditors and from bankruptcy. If you change employers or lose your job and cannot repay the loan, you now may owe money to the IRS for income taxes and penalties.
For example, assume Chris has $25,000 of credit card debt and $50,000 in his 401(k) plan.
He borrows $25,000 to pay off his debt. He accumulates additional debt and later ends up filing bankruptcy. If had left the $25,000 in his 401(k) plan, it would be a protected asset and the bankruptcy court could not touch it. Since he withdrew it and paid off debt, now he not only has bankruptcy, he must continue to repay the $25,000 to his 401(k) plan rather than having the bankruptcy eliminate that debt.
If he had filed bankruptcy instead of borrowing the money out of his 401(k) plan he would come out of bankruptcy with $50,000 still in his 401(k) plan, a tremendous start to rebuilding his financial future. After bankruptcy, if he does not repay the 401(k) loan it will be considered a taxable distribution, and he will owe taxes on the $25,000.
Tax debt cannot be eliminated by bankruptcy.
Before you borrow money from your 401(k) plan to pay off consumer debt, consider all options to eliminate debt, including bankruptcy. If you choose to borrow from your plan, do so only with an absolute commitment to getting and keeping your finances in order.
Alternative to Borrowing From Your 401(K)
Some 401(k) plans allow hardship withdrawals for things like unexpected medical expenses or to prevent eviction. If you take a hardship withdrawal you will pay taxes on the amount you withdraw in the year you withdraw it.
If you are in debt, consider working with creditors to establish a debt repayment plan, or talk to a bankruptcy attorney about the option of using bankruptcy to wipe out your debt while preserving your 401(k) and other retirement money.