At first glance, borrowing money from your 401(k) plan may seem the easiest, cheapest, and most sensible way to get the funds you need for a major purchase (like a new home or a car), to consolidate other debt, or for any other reason.
After all, it’s your money. You don’t need to fill out any lengthy forms or reveal personal credit information, the interest rate is usually lower than a bank or lending institution, repayment is easy, and you’d be paying the money, plus interest, back to yourself.
In some cases, this may be true if you really need the funds and don’t have any other suitable alternative. But there are drawbacks to borrowing from your retirement plan that can have a major impact on your future by limiting the amount available to you at retirement.
You lose the compounding advantage.
One of the major advantages to saving in a 401(k) plan is the ability of your money to compound on a tax-deferred basis. Over time this can be a powerful tool in building funds for your retirement. Borrowing from your account slows that compounding growth and you lose the time value of the money you borrow. The amount you borrow from your 401(k) account immediately stops earning whatever investment returns you would earn if it remained invested in the available funds.
Paying yourself interest isn’t that good a deal.
Your loan repayments are made with after-tax dollars. But that money is being paid into a tax-deferred plan account. When you are ready to retire your distribution (including your loan repayments) is considered a taxable event. This means your 401(k) loan payments are taxed twice. In addition, a loan from a retirement plan is considered a consumer loan and the interest is not tax-deductible, as it would be for a home equity loan.
The disaster of default.
Perhaps the most compelling reason not to borrow from your 401(k) plan is what can happen if you terminate your plan with an outstanding loan balance–or if you are simply unable to make your payments. If you terminate your plan for any reason while you have an outstanding loan, the remaining loan balance is due immediately. If you can’t afford to repay the loan in full, the entire outstanding principal becomes taxable and is deemed to be a distribution.
This can spell disaster.
Not only will you have to pay a tax on the distributed amount at your regular tax rate you will also be hit with a 10% non-deductible Federal tax penalty and a state penalty if the state you live in has one (if under age 59½). Depending on the amount it adds to your taxable income, the loan distribution may actually push you into a higher tax bracket–making costs even higher. The additional costs created by a loan default can be financially devastating.
Of course, it’s still comforting to know that if the need arises you do have access to your 401(k) funds. But if you consider taking a loan against your retirement, be sure to take all the consequences into consideration.