Over the years, many 401 (k) plan participants have approached me regarding the benefits and drawbacks of taking a loan from their 401 (k) account. Often, the co-worker who approaches me has already concluded that borrowing from their 401 (k) account is a good idea. After all, there is usually a qualifying need for the money – such as using the borrowed money to pay off a high interest credit card. Part of their conclusion is the fact that the interest on the loan will be paid back to their 401 (k) account – not to the credit card company or a bank.
Although the thought of paying back the interest to yourself is appealing, think long and hard before taking a loan from your account. In my discussions with my co-workers, I have stressed that they consider the following before borrowing from their 401 (k) account:
1) Although you are paying yourself back with interest, your money is not invested in the stock market.
You may be lucky and manage to pay back most of the loan while markets decline, but that is illegally. Just look at any chart on market performance, and over the majority of 5 year periods and over nearly all 10 year periods, stock markets have increased in value. I am a firm believer that you want to stay invested in the market as long as possible so that you benefit from all of these stock market increases. Simply put, I believe the longer you are invested in the stock markets, the better your performance will be. Taking a loan reduces the amount of money one has at work in their 401 (k) account. Simply missing one stock market "bull run" while having borrowed a significant amount of your 401k can set your retirement piggy bank back for years to come.
2) The payments necessary to pay back your loan will lower your take home pay.
Although all the employees I have counseled understand that regular paycheck deductions would occur after taking a loan from their 401 (k), many failed to truly budget for this lower take home amount.
For example, many employees who consider borrowing from their 401 (k) account do so in order to pay off a pesky credit card bill. After all, that credit card company is charging interest of 15% or higher. By borrowing from their 401 (k) account, one can eliminate the credit card debt and then pay the loan off through regular payroll deductions.
That approach sounds good in theory. In practice though, reality creeps in. Many of my co-workers who borrowed from their 401 (k) account to pay off credit card bills would regularly approach me a few months later. Often, these employees would be asking to either take a second loan from their 401 (k) plan or asking if their existing 401 (k) loan could be re-structured in such a way to lower their paycheck deductions.
What happened? Why do they return to the piggy bank so soon after paying off their pesky credit card debt? Often, these employees did not address their appetite for credit before borrowing from their 401 (k) account. Paying off their credit cards simply allowed many of them to incur more credit card debt. Then these employees had to deal with the double whammy. Not only did they once again have that credit card payment, their paychecks were lower since they were already paying off a 401 (k) loan.
I strongly recommend that anyone looking to use a 401 (k) loan to pay down credit card debt look to control their use of credit cards first.
3) Risk of unemployment
What happens if you have an outstanding loan and you lose your job for whatever reason? The short answer is you could have as little as 4 to 8 weeks to pay off the entire outstanding balance. If you fail to pay off your outstanding loan balance the outstanding loan amount will be valued as a distribution from the plan. This means that you will owe taxes on the amount you failed to pay back to your 401 (k) plan account. Participants under age 59 will will be assessed a 10% tax penalty in addition to the tax obligation due on the unpaid loan balance.
4) Negates the tax advantages of your original contribution
A loan from a 401 (k) plan is essentially borrowing pre-tax dollars from your account and then repaying the loan with after tax dollars. So although you gain the benefit of yourself back with interest, you actually negate the tax deferral advantage because you repay the loan with post tax dollars. On top of that, when you withdrew the money you used to pay off the loan, that money is taxed yet again.
There can be borrowing reasons to borrow from your 401 (k) account, but I recommend anyone considering such a step to fully understand the consequences of their actions – even if that money is going to pay off a high interest credit card or toward the down payment of a house. Do the following:
1) Talk to someone in your human resources department to make sure you understand the costs – including the reduction in your take home pay.
2) If the funds are being used to pay off a high interest credit card, take a look at your use of credit and figure our how to eliminate your reliance on this all to easy to use debt creator.
3) Budget for your lower take home pay. This is a very important consideration, especially if you plan to use your loan as a down payment on a house.
Furthermore, I have always used such discussions as an opportunity to recommend that my co-worker look to control or eliminate other expenses such as unheeded health club memberships, rarely watched subscription TV channels and overly expensive cell phone bills first. Even if you still decide to borrow from your 401 (k) plan, lowering or eliminating these other discretionary expenses will help to offset the lower take home pay you will have.
Although I rarely advise anyone to borrow from their 401k account, taking these steps before you borrow should help you manage your paycheck better after you take a loan.
Copyright © 2009 by Jeff Brownlee