Why Your 401(k) Is Not A Bank

Written By
Paul Tracy
Updated January 16, 2021

Drastic times call for drastic measures, especially these days. But when it comes to raiding your 401(k) in order to pay bills or buy things, it's incredibly important to understand the consequences first.

How Borrowing Against a 401(k) Works

The basic idea behind borrowing against a 401(k) is that an employee withdraws money from his or her 401(k) account but agrees to pay it back with interest over the next five years. Usually the employee can borrow the lesser of $50,000 or 50% of the 401(k) account's vested balance. The employee essentially borrows from their own money and avoids paying state and federal income taxes on the distribution, as well as the huge 10% tax penalty tacked onto early 401(k) withdrawals.

The IRS generally does not impose the penalty if the loan is repaid within five years. (If the money is used to buy a house, that time limit doesn't apply.) Some plans will allow borrowing only for education or medical expenses.

The paperwork process and timing associated with borrowing against a 401(k) varies from plan to plan, but the IRS requires "substantially level" payments at least quarterly over the life of the loan. If the borrower is on an unpaid leave of absence or on a paid leave of absence that pays less than the required loan payments, the borrower doesn't have to make the regular payments, but the loan is still due in five years. The leave of absence typically can't exceed one year, per the IRS.

The big selling points for borrowing from a 401(k) is that the interest rate on these loans might be lower and that borrowers are paying themselves back instead of some bank that may or may not like their credit scores. But there are some other considerations that make the idea a little less attractive.

You're in Double Trouble If You Get Laid off or Quit

In many cases, the loan is due and payable even if you lose your job or quit. That means saying no to better opportunities if you don't have the cash to pay off the loan right away. To boot, if you don't repay the loan on time -- even if you still have your job -- you'll owe state and federal income taxes on the money and the IRS will tack on a 10% early withdrawal penalty if you're under age 59.5.

You Handicap Growth in the Account

Many 401(k) plans don't allow you to make more investments in your 401(k) plan if there's a loan outstanding. All your contributions flow toward paying down that principal first. Thus, you could be missing out on buying opportunities in the market. Some plans also tack fees onto the loan payments, further eroding your account balance.

That Low Interest Rate Can Be a Bummer When You Consider It's Also Your Rate of Return

In other words, not only are you in a situation in which your borrowed funds aren't rapidly appreciating, but you're its sole source of return. Thus, that low interest rate may seem great when you're the borrower, but when you consider that you're also the lender, it's a real problem when you're earning, say, 3%, and everybody else is earning 10%. Considering the compounding effects, the long-term implications of borrowing against your 401(k) when you're young can make a huge difference in your lifestyle when you retire. And because the loan is considered a consumer loan, there is typically nothing about a 401(k) loan that is tax deductible.

You Lose the Tax-Deferred Status of the Borrowed Funds

401(k) accounts are typically funded with pre-tax dollars. However, when you repay a loan, you pay with after-tax dollars. Think of it this way: When you first funded your account, you need to earn $500 on a pre-tax basis to fund $500 in the account. But for an investor in the 28% bracket paying back a $500 401(k) loan, they must earn $694 on a pre-tax basis.

In general, borrowing from your 401(k) isn't the convenient and advantageous experience some people make it out to be. But if the situation is right, it can work for some. Don't make the decision lightly and don't borrow the money to pay for something unnecessary like a vacation. After all, dipping into your retirement funds is a red flag that might be living beyond your means.

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