401(k) Loans: Stop Using Your 401(k) as a Bank
401(k) loans are attractive because you don’t need to have good credit, you enjoy low interest rates, and you pay interest to yourself instead of a creditor.
Taking a 401(k) loan may make sense in some situations, but if you don’t know what you’re getting yourself into, it could cost you more than you bargained for.
Specifically, a 401(k) loan can impact the quality of your retirement, have negative tax consequences, and cost you money and opportunity.
401(k) Loan Rules
Not all plans allow for investors to borrow against their 401(k)s. However, for those that do, here are the rules according to the IRS:
- You can borrow up to what your 401(k) plan allows.
- While there are a few exceptions, you must pay back 401(k) loans within 5 years.
At 401(k) Maneuver, we advise our clients not to treat a 401(k) like a bank because borrowing now may have serious consequences for your retirement future.
With healthcare costs rising and the future of social security uncertain, you need all the retirement savings you can get.
Before you run out and borrow from your retirement account, check out these 5 reasons not to take out a 401(k) loan.
#1 It Costs You More in the Long Run
When you take out a 401(k) loan, you pay the interest to yourself. However, you are borrowing money contributed with pre-tax dollars, and repayments are made using after-tax dollars.
When you take out money for retirement, you are taxed on the distributions at your ordinary income rate.
This means you are taxed twice. Once when you use after-tax dollars to pay off the loan and again when you withdraw those same dollars in retirement.
#2 You May Not Be Able to Make Regular Contributions
Some 401(k) plans prohibit you from making additional contributions until the loan is paid off.
If your plan has this provision, taking a 401(k) loan may significantly impact your future 401(k) balance because you’ll be missing out on compounded earnings. If your employer offers company matching, you’ll miss out on those additional funds as well.
Not being able to regularly contribute also has tax consequences, as you’ll not be able to write off the pretax income you would have otherwise put in your 401(k).
Even if your plan allows you to make regular contributions while repaying the loan, you run the risk of not being able to afford contributions while paying it off.
#3 Anything Can Happen to Your Financial Situation
If something happens to your financial situation and you fail to make the payment by the due date or the plan’s grace period, it can trigger a default on the loan. When this happens, the loan is converted to a withdrawal.
Unless you qualify for a hardship withdrawal, the loan balance will be taxed at your current income level. Also, if you are under age 59½, you will have to pay a 10% early withdrawal penalty on the amount borrowed.
#4 You Could Lose Your Job before You’ve Repaid It
If you lose your job or you quit before the 401(k) loan is repaid, you have to pay off the outstanding balance in a much shorter time frame than originally planned.
Under the Tax Cuts and Jobs Act (TCJA) passed in 2017, 401(k) loan borrowers have until the due date of your tax return for the year of distribution to pay it back.
This means that if you lost your job and the distribution of the unpaid loan happened in March of 2021, you’ll have until April 15, 2022 (when you file your tax return), to fully pay back the loan.
If you cannot repay the loan balance in the mandated time frame, the loan will be treated as an early withdrawal. Should this happen, not only will you have to pay the 10% early withdrawal penalty if you are under age 59½, but you’ll also owe income taxes on the full balance of the loan.
#5 You Could Miss Out on Other Career Opportunities
If you’re tied to a 401(k) loan and need to stay with your employer until it’s repaid to avoid penalties and possible default, you may miss out on new job opportunities. Or worse, be stuck at a job you dislike.
Just like losing your job, leaving before the loan is paid off means you’ll have until the date of your next tax return to pay off the loan – much less time than the 5 years you planned on.