Learn the Pros and Cons of Borrowing From Your 401(k)
Taking a Loan Could Mean Double Taxation on the Interest
Pros and cons exist when it comes to taking out 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 want to check the rules on your plan to see if it allows loans, by either reading your plan's 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 five years.
- You'll pay double taxation on the interest component. You are now paying interest back into your 401(k) plan with after-tax money, while you originally contributed in pre-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 money plus 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 repaying your loan, 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 your 401(k) money to pay debts, when in fact this money would have been protected from bankruptcy for your retirement.
Reasons People Take 401(k) Loans
People typically borrow money from their 401(k) for the following reasons, which don't necessarily make good sense:
- To fund a business start-up.
- To help a grown child.
- To buy a car.
- To pay off other debt.
For the most part, borrowing money from your 401(k) plan for these items is not a good idea because you are hurting your future retirement savings and missing out on compounding interest. 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, think very carefully before you borrow it out and void that protection. Explore all other possible 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. For example, a business person can repeatedly borrow and repay money from a 401(k) plan to help fund the acquisition of different businesses.
Success hinges upon them understand the repayment clause, following all the rules and most of all, always putting the money back into the 401(k) 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 haven't really improved anything. 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 he 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.
Alternatives 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.