While you might be able to borrow from a 401(k), that doesn’t mean you should. Yes, we are in a recession. Yes, times are tough. But borrowing from your 401(k) could prove highly detrimental to your financial health.
Some 401(k) plans will not even allow you to take a loan. Those that do commonly permit you to borrow up to 50% of your vested account balance or $50,000, whichever is less.1 How do you pay the money back? You pay it back (with interest) from future paychecks. How long have you got to pay it back? Usually, up to 5 years. If you use what you borrow to buy a home that will be your primary residence, you may be given longer to pay back the money.2
But again, this doesn’t mean you should. Here’s why this idea belongs in the category of “last resort”.
It could pressure you to reduce your 401(k) contributions. You’ll repay the loan out of your paychecks. Can you do that and continue to contribute to your 401(k)? If you have to lessen or cease 401(k) contributions as a consequence of this move, it could further hurt your retirement savings potential, especially if your company offers you a match on contributions.
If you can’t repay the loan, it becomes a distribution. If you can’t pay the money back within the time period allowed, it is considered a distribution, subject to federal and state income taxes. If you are younger than age 59½, you will face the usual 10% penalty for making a premature withdrawal from your retirement account on top of that.1
If you lose your job, guess what: in most cases, you have to pay the loan back within 60 days, or it becomes a taxable distribution. Ow.3
The money isn’t tax-sheltered after you borrow it. Nor is the loan tax-deductible.1
It works against the time value of money. In other words, compounding. One of the key tenets of investing is that money available to you now is worth more than money available to you in the future. Any money you put in a bank account or tax-advantaged investment account now has potential earning capacity – the capacity to grow and compound over time.
This is why we would all prefer to have, say, $20,000 to invest today rather than $20,000 to invest 30 years from now. If you wait 30 years to invest it, you will lose 30 years of time value. Additionally, that idle $20,000 will be worth less 30 years from now due to inflation.
If you borrow from your 401(k), you are working against the time value of money and the power of compounding. By removing assets from that tax-advantaged account, you are hindering its potential earning capacity.
Every 401(k) plan loan carries an opportunity cost. Years from now, you may have to reckon with some sobering questions – how much could those funds have earned if they were left inside the 401(k), and how much did they earn for you when you took them out of the 401(k)? Did the money you borrowed earn you a dime? Did you take on another debt using the money you borrowed?
Are you paying yourself interest? Think again. As you pay back a 401(k) plan loan, the 401(k) program puts the principal and interest back into your 401(k) account. So it looks like you are paying yourself interest. Technically, you are. But to pay that interest, you need to earn money (a salary) and pay income tax on what you’ve earned. You pay the interest on your loan with post-tax dollars. Guess what: when you withdraw those dollars from your 401(k) at retirement, they’re taxed again (as taxable income). So in essence, those dollars are being taxed twice. (It must be noted that specific tax rules apply to Roth 401(k) contributions.)2
Why harm your retirement fund? Borrowing from your 401(k) could amount to an injurious financial mistake, one that could haunt you for years. If the thought has crossed your mind, talk with us or a tax advisor – there may be other ways to find the money you need.
These are the views of Peter Montoya Inc., not the named Representative nor Broker/Dealer, and should not be construed as investment advice. Neither the named Representative nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information.
1 moneycentral.msn.com/articles/retire/basics/4714.asp [3/13/09]
3 washingtonpost.com/wp-dyn/content/article/2009/03/11/AR2009031101002.html [3/11/09]