6 Reasons Taking a Loan from Your 401(k) Is a Bad Idea
Mar 7, 2022
2 min read
If you鈥檙e deep in debt and not sure how to get out, borrowing from your might seem tempting. It鈥檚 a pot of money that鈥檚 not tied to any application process, scrutinizing lenders or credit score requirements. Easy fix, right?
Unfortunately, the reality isn鈥檛 so simple. Consider these six effects of borrowing from a 401(k) to help you make the best decision.
1. You Must Pay Back Your Loan
That is, if your 401(k) plan offers loans in the first place. The reality is not all 401(k) accounts allow borrowing. For those that do, if of more than $10,000, you can borrow up to 50 percent or $50,000, whichever is less. Some plans make an exception for balances below $10,000, allowing a loan of up to $10,000. Either way, you鈥檒l be able to access money quickly depending on your balance. But one of the 401(k) loan disadvantages is that paying back those funds will take a long time. Payments usually occur over five years and come out of your paycheck. That means less monthly income for you. And if you leave your job before this period, you may have to pay your remaining balance within 60 days.
2. You May Need More Money
If you鈥檙e considering borrowing from your 401(k), ask yourself why you need the funds 鈥� and how much of it you need. Are you paying off a debt? Are you buying property? Are you renovating your home? A 401(k) loan has limits, and depending on your financial situation, you may not have access to as much cash as you鈥檇 like. The maximum loan amount for most 401(k) plans is $50,000 or 50 percent of your vested account balance, whichever is less.
3. Your Money Loses Its Protection
In general, money you鈥檝e saved for retirement 鈥� i.e., pensions and 401(k) plans 鈥� is protected by federal law and in some cases, state law, from creditors should you run into financial trouble. This is thanks to the Employee Retirement Income Security Act (ERISA). If you鈥檙e in serious trouble and hoping your 401(k) loan will bail you out, consider other strategies first. Once assets are withdrawn from an ERISA-qualified retirement plan, they lose all protection. 鈥淪hould I borrow from my 401(k)?鈥� The short answer: Not if you don鈥檛 want to give creditors access to money that is currently shielded.
4. You鈥檙e Borrowing from Your Future Self
As you鈥檙e weighing the pros and cons of a 401(k) loan, consider this: While you have an outstanding 401(k) loan, you most likely won鈥檛 be able to continue regular contributions, either because your plan has a provision that prohibits you from making contributions until the loan is paid off or because you鈥檙e simply unable to afford do. And without making regular contributions, you end up severely limiting the growth of your retirement fund. It鈥檚 a vicious cycle of paying back what you鈥檝e taken out, and it鈥檚 one that will probably also mean a reduced or delayed retirement payout down the road. This may turn out to be a huge retirement planning mistake.
5. You Lose Tax Deferment
The beauty of contributing to a traditional 401(k) lies in avoiding paying taxes on that money until you withdraw. However, if you borrow from a 401(k) to pay off debt, the funds you鈥檙e borrowing were contributed on a pre-tax basis but now you鈥檒l be paying back the loan with after-tax money. That taxed income will then be taxed upon withdrawal when you鈥檝e reached the proper age. To illustrate, if you fall within the 24 percent tax bracket, every $1 you earn to repay your loan leaves you just 76 cents for actually repaying your 401(k) loan. The rest? To income tax. Ouch!
6. You Probably Have Better Options
While a 401(k) loan can be a good idea for someone in strong financial standing who needs assets quickly, it鈥檚 a slippery slope for someone in debt. If bill collectors keeping calling, first see what else you can do to ease the pressure. Work to set up a payment schedule and create a budget. With some careful financial management, you can make a dent in what you owe. Borrowing from your 401(k) should be your last resort.
Should You Borrow from Your 401(k)?
Talk to your Farm Bureau advisor about your financial goals and how we can help you achieve them.