Friday Financial Tidbit-Why taking out a loan on your 401(K) is a bad idea

Workers who are taking loans on their 401(K) plans are on the rise. In August 2010 the percent of 401(K) accounts with loans on them was at 22 percent, a 10 year high. The average outstanding balance was $8,650 with payments spread out over three and a half years. Borrows may borrow up to 50% of their balance up to a maximum of $50K and repay over a 5 year period. One of the main draws of the 401(K) loan is that you pay back the interest to yourself and not the bank. However, I recommend avoiding them at all costs for several reasons.

The main reason I do not recommend them is because they have a very risky downside. If for some reason you leave your job, you have 60 days to re-pay the loan in full or the IRS considers the loan an early withdrawal. This means you will be charged a 10% penalty, plus your tax rate! So you are probably looking at the government taking anywhere between 35-40% if you lose your job. I know, I know, your job is secure and you will not leave. But layoffs as well as unexpected illness do happen and the last thing you need is a $10,000 tax bill from the IRS when you are out of a job and have no money.

Another reason to avoid them is the lost opportunity to grow your money. By loaning the money out to yourself, you are unplugging money from a fund that has the ability to grow more then the interest you are paying back to yourself. If you take a $20,000 loan out over five years and pay yourself back 4%, you will have ~$24K at the end of the five years. But if you leave them in good fund that average 10% over the time frame, you will have ~$32K at the end of the five years. That’s about $8K or 33% more then if you had borrowed your own money and paid it back!

Use a 401(K) for its intended purpose, saving for retirement. Using it as a vehicle for loans or emergency savings is a bad idea. If you treat your 401(K) like a savings account you likely end up with less in retirement because you will be constantly unplugging good funds and your growth will become stagnant. Instead of taking out a loan against your 401(K), I would rather you just take out a hardship withdrawal, but only to prevent a foreclosure or bankruptcy. That way you would know ahead of time what the tax consequences are and you can prepare accordingly. So resist the urge to borrow your own money and instead watch your retirement savings grow.

How about you?  Do you agree or disagree with me on taking out a 401(K) loan?

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About Jon White

Giving people hope and seeing them win with their finances is something I have a strong passion for. Because of this passion I started JW’s Financial Coaching in the summer of 2010. Financial coaching has allowed me to combine my passions of finances, teaching, and helping others by helping people get on the right track financially. I'm interested in hearing your story so please do not hesitate to interact with me through social media.
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