Borrowing from your 401(k) plan was once considered an advantage of participating in an employer-sponsored plan. While it may still show up on the list of plan benefits employers and 401(k) plan service providers are so fond of, is it a good idea?
Sure, borrowing from your 401(k) account has its pluses, especially when you need money fast:
- You don’t have to apply for a loan if you meet plan requirements.
- No one checks your credit score.
- You generally have five years to pay it back, which you can do through automatic payroll deductions.1
There are some serious downsides, however. Before you borrow from your 401(k), keep the following points in mind.
What is it really costing you?
Costs of a 401(k) loan may come in multiple forms. When you take a loan from your plan, that money is no longer invested, so you’re missing out on potential market gains and losses. For most 401(k) loans, you also pay the money back to your account with interest. The good news is that the interest is going straight back into your account, and not into a lender’s pockets. The bad news is that the amount of interest you’re paying is often not high enough to make up for the earnings you may have made if the money had stayed invested. Finally, many employers charge an initial fee to take out a loan, along with ongoing loan maintenance fees. Unlike interest, that’s not money that will ever go back into your account.
You’ll owe the full amount and then some.
The costs continue to add up if you leave your employer before your loan is paid off. If you take a loan from your account and then quit your job or get laid off, you may owe the full amount of your loan within 60 days. If you don’t meet your payment deadline, the loan will be considered a distribution and you’ll owe income taxes on the outstanding amount. On top of all that, you’ll also have to pay an extra 10% penalty because it counts as an early withdrawal.2
Missing the match can hurt.
Many employer-sponsored plans won’t let you contribute to your account until you pay off your loan. That means you could miss out on another big 401(k) plan benefit: employer matching contributions. If neither you nor your employer is contributing to your account, the impact to your retirement savings could be significant.
It could happen again.
You may need money now, but think about why before you take out a loan. How did you get into this position? Is your current financial need a symptom of bigger saving and spending problems? If so, you may want to reconsider that loan. A 401(k) loan might help in the short run, but you may not have solved for what made you take a loan in the first place.
It’s your retirement, remember?
While loans are generally permitted in 401(k) plans, don’t forget what your account is for in the first place. That’s right, your retirement. The more you borrow against your retirement savings, the less you have working for you in the long run.
Loans have been a big part of 401(k) plans for as long as anyone can remember. But that doesn’t mean it’s your best option in times of financial need – and in fact, it should generally be considered a last resort. Think through your options and the consequences before you borrow from your retirement savings.