We’ve all been there. An urgent financial problem comes along, or an opportunity to invest in something outstanding, or that beach vacation is screaming your name and all you can think of is, “I can take a loan from my 401K. It’s easy and I’ll pay it back.”
In a word: Wrong.
Unless you absolutely have no other option and you are in SERIOUS trouble (hospitalized in a foreign country for example) you should never use your 401K for a loan.
Your 401K is there to help you after you retire, when your income earning days are gone. No one wants to think about spending their retirement years living off Ramen noodles and watching dogs’ water the fire hydrants outside the window of your rented room for entertainment. Your 401K is designed to prevent that scenario from becoming fact.
Need a little more incentive? Check out the 4 biggest reasons you should never borrow from your 401K unless it is literally a life or death emergency:
Taxes and Fees Cost You Big Bucks
Let’s say that you do manage to repay the loan from your 401K; you are doing it with after tax money, not pre-tax money like your 401K contributions.
After you have retired, you will be taxed on the amount of money you withdraw from your 401K. The tax man will not differentiate between pre-tax contributions and after-tax repayment money, this means that not only are you paying taxes on your loan repayment money, you will be taxed a second time when you withdraw funds after retirement.
Also, most financial institutions charge fees for early withdrawal of retirement funds. Depending on where your 401K is parked, that might cost you more than the fees from a conventional loan.
There is a BIG Tax Bite if You Don’t Pay It Back
Most 401K loans are repaid with quarterly payments and these loans must be paid back within 5 years. That sounds like light years away when you have a pressing financial need today, but you should know what happens if you don’t repay that loan- you get taxed on the entire unpaid balance of the loan. To add insult to injury, you will also have to pay a 10% penalty for taking that money out early.
There are exceptions to these rules, of course, but for the most part, the tax rate and early penalty fee is going to hit you really hard come tax time if you somehow can’t repay the loan.
Want to Work Even Longer?
Let’s say that you decide you are going to hit the road and retire at 60, but you still have an outstanding 401K loan. If you have the cash to pay it back, then there is no problem, but what if you don’t? This means you will have to continue working until you pay off that loan. Depending on the size of the loan, this could take you years to accomplish. Or you can choose to pay those hefty tax fees and early withdrawal penalties the tax-man dishes out. There are no good choices here.
Want to Lose Even More Money?
Most 401K’s are invested in multiple funds. When you take a loan, part of the loan comes from each funding source. If your money is invested in 4 mutual funds, for example, they would withdraw ¼ of the loan from each mutual fund.
This means that the money you pulled out is no longer making you money. All the earnings from those missing funds are like flushing cash down the commode.
When you take a hard look at the fees, the possible tax consequences, and lost investment earnings, it’s pretty clear that you should simply say NO to a 401K and look to other sources to get yourself out of your cash shortage.