As a very last resort, employees with active 401(k) retirement accounts have an option to take out a loan against their future. Borrowing money is never a good position to be in, but if you’re borrowing money from yourself, you ease the pain. 401(k) plans permit borrowing at interest, and paying interest to yourself can help improve your finances in retirement.
The existence of a 401(k) account is often used as an excuse for not creating an emergency fund; if a loan is available at any time, why settle for low high-yield savings accounts when your money could be put to better use? This isn’t a valid argument as elucidated by the dangerous drawbacks of 401(k) loans.
Most people who take out 401(k) loans stop contributing new earnings to their 401(k) plans. Not only is the withdrawn loan not earning more or increasing value in your retirement account, you’re not adding new investments.
One of the most popular emergencies requiring more cash is the loss of a job. If you lose your job, you won’t be able to take a loan from your 401(k). Additionally, if you already have a 401(k) loan when you lose your job, it will be due within 60 days or less. At the same time you need cash, you’ll need to pay back your loan or suffer income taxes plus a 10% penalty. According to a recent study by Aon Consulting, 70 percent of workers who lose their jobs while having an active 401(k) loan default on that loan (pdf).
Even if the 401(k) loan is paid back in full, there’s another drawback. The interest on the loan is considered income, and therefore taxed, twice. When you pay interest back to the 401(k) account, it is paid with your regular income, which would be included on your tax return as taxable income. Once that interest is in your 401(k) account, it is mixed in with the before-tax contributions, if your loan was from the before-tax portion of your 401(k). When you retire and you withdraw your funds, the full amount of your before-tax contributions and their earnings will be subject to income tax. You could also argue that the principal portion of the loan payback amounts are taxed twice as well, because a 401(k) loan payback is not considered tax-advantaged and does not reduce your taxable income like a 401(k) contribution.
Congress is currently mulling legislation to limit 401(k) loans. If the law passes as it currently stands in bill form, employees could only take three loans against their 401(k) at a time. Repeated borrowing just sounds like trouble. The law would allow employees to continue contributing to 401(k)s while a loan is outstanding. I would think if any extra money is available, it would be better served paying off the loan rather than making new investments. I suppose it could be more tax efficient this way, but paying off debt should be a priority, even if the borrower is the same individual as the lender. Third, the law would ban 401(k) accounts from issuing debit cards that allow investors to use retirement funds as a transaction account. This sounds reasonable.
Some 401(k) plans might be more restrictive than the law. In most cases, borrowing from a 401(k) is just a bad idea. It’s tempting in emergencies, though, particularly for households that have not been able to create an emergency fund. A 401(k) loan should be a last resort. If you get stuck and are unable to pay the loan, the government takes a big chunk. On a $10,000 loan, assuming 25% federal taxes, 5% state taxes, and a 10% penalty, you’ll only be able to keep $6,000.
Have you or would you borrow from your own 401(k)?
Updated August 20, 2011 and originally published August 1, 2011. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.