Ideally, never…or at least rarely. Plundering our retirement piggy banks can be tempting when a financial emergency arises or perhaps when we are looking for cash to finance a home purchase or to pay off some high interest credit cards.
Although IRS rules do allow for retirement plan loans, the maximum loan size is either (1) the greater of $10,000 or half of your vested 401(k) balance or (2) $50,000, whichever is smaller. While borrowing from yourself in this way can be convenient and seem relatively harmless, this type of short term fix may have some long-term consequences that are more expensive than we realize.
401(k) loans seem attractive…at first. On the one hand, borrowing from our company retirement plans is tempting for several reasons:
- No credit check is required and consequently, it will not affect your credit score.
- The interest rate is potentially lower than that of a traditional loan.
- You pay back the loan conveniently through payroll deduction.
- You are borrowing your own money and paying yourself back with interest. Where’s the harm, right?
Then things can get ugly. A closer examination of exactly how all of the moving parts work as well as some of the things that could potentially go wrong might lead you to conclude that getting a bank loan, borrowing against home equity, selling other assets, or even borrowing from family might be better for you in the long run. Here are some of the reasons to think twice before taking out a 401(k) loan:
You will pay taxes on the same money twice. It is true that you pay yourself back with some interest, but you also use after tax dollars to make those interest payments. In the future, when you spend your pre-tax 401(k) money in retirement, those future interest distributions will be taxable as ordinary income, meaning you actually pay taxes twice on that money.
Lost growth and compounding. The money you borrow from your 401(k) is temporarily removed from the underlying investments, missing out on any market growth, interest, dividends, etc. The double whammy comes from the missed opportunity for this growth to be reinvested and earn even more through compounding, which is the financial superpower that comes from investing – and staying invested over time.
Treating your 401(k) like an ATM. Once you dip into your retirement stash and use it to relieve some type of financial pain, you can begin to slide down a slippery financial behavior slope. Having rewarded yourself once with a relatively easy source of cash, you run the risk of training your brain to think of this strategy as a reasonable substitute for creating and maintaining better financial habits, such as regularly saving cash in an emergency fund, sticking with a budget, or increasing your retirement plan contribution rate. Staying faithful to healthier financial priorities helps you avoid disturbing your retirement plan’s progress by treating it like an automated teller machine and dipping into it multiple times.
Less take-home pay. While you are repaying your loan, your paycheck will be reduced by the amount of the loan repayment. If your cash flow was tight before raiding your retirement fund, you may soon discover that it becomes even more challenging with a reduced paycheck.
Severe taxes and penalties. If you leave your employer for any reason – whether it is your idea or if your employer fires you – you might have to repay the entire remaining loan balance within as little as 60 to 90 days. This requirement varies from plan to plan. Some company retirement plans allow you to continue making the scheduled loan repayments without having to pay it all back early.
However, your payments obviously will no longer come from payroll deduction once your job ends. If your period of unemployment is lengthy, you might not be able to keep up with the required repayment schedule.
Once you default on a 401(k) loan, the IRS then treats any remaining balance as a taxable distribution. If you are under age 59 ½ at that time, there may be an additional 10% tax penalty for taking an early withdrawal from your retirement plan. What was once a temporary financial fix could quickly become an expensive tax bomb.
It might be okay to borrow once, if:
You have high interest rate (think double-digit) debt and you have exhausted all other opportunities to refinance or negotiate a lower interest rate. The ongoing challenge will be to reduce any temptation to begin using the same high interest credit cards or loan sources again and recreate the problem. Once you pay back the 401(k) loan, take that monthly loan payment you were making and redirect it to a savings account at your bank, building up an emergency fund you can use for future financial emergencies, rather than raiding your retirement plan like a pirate.
You owe the IRS back taxes. With interest and penalties stacking up on overdue taxes, this financial burden can become very serious over time. In this case, a 401(k) loan might be your saving grace. However, you may qualify for relief under the IRS guidelines for alternate payment plans and hardship
You are in real danger of defaulting on a student loan. In most cases, bankruptcy is not an option for these.
You are facing imminent bankruptcy or eviction from your home.Talk to a nonprofit consumer credit counselor (nfcc.org) about alternatives to bankruptcy. If a 401(k) loan can buy you some valuable time while you restructure your cash flow and other investments to support a sustainable strategy and repay your 401(k) loan, this might be an appropriate financial move.
The important thing to keep in mind regarding loans from your retirement plan is to make sure you address the underlying need for cash rather than simply assuming the 401(k) loan will solve the immediate problem. Otherwise, you could find yourself on an unhealthy financial treadmill where you repeatedly borrow from your 401(k) and begin to seriously jeopardize your ability to retire on time, comfortably, or both.
A good way to see just how damaging and expensive a retirement plan loan can be to your financial future is to use the National Center for Policy Analysis’ (NCPA) 401(k) Borrowing Calculator. This calculator shows how much less money you may have for retirement if you borrow from your retirement plan versus not taking out a 401(k) loan.
Bottom line: make sure you have carefully considered all other alternatives before you undo much of the hard work you have already invested in growing your retirement nest egg.
This post was originally published on Forbes, August 3rd