401k Loans – Borrowing Money From Your Retirement Plan Is A Bad Idea

by Hank Coleman

Almost every single 401k retirement plan has a loan option, but that does not mean that you should use it and take a loan out against it. In fact, borrowing money early in your career from your retirement plan can rob you of hundreds of thousands of dollars in lost retirement income later in life.

Stunted Growth. I took out a loan from my 401k one time to consolidate some credit card debt and other consumer loans, and it was one of the worst financial mistakes that I have ever made. The amount of money that you borrow is taken out of your 401k balance. So, that amount of money will not be present in your account to earn interest. You might think that that is a no brainer, and you might consider that not such a big deal because we are only talking about three to five years of your early working life. But, the interest that you did not earn during those years will never make you interest. It might be a hard concept to grasp. But, the best thing that any investor has going for him or her is the awesome power of compounding interest. Your interest will earn interest, and that is how you can get your money to double every nine years or so increasing your retirement nest egg exponentially. Taking out a loan will rob you of future interest…pure and simple.

For example, if you take out a $10,000 loan for three years, you will forgo roughly $800 in interest every year for a total of $2,400 in lost interest (assuming 8% annual growth). $2,400 would grow to a little over $24,000 over a 30 year career. That is $24,000 lost from your retirement nest egg that you will never be able to get back. That is the real cost of your 401k loan.  

The Only Good Point. The one good thing about taking out a 401-k loan is that you are paying yourself back with interest. I always though my balance was shooting up because I was still contributing to my 401k plan while making my monthly loan repayments. So, it seemed on paper that I was contributing double for a few years. Some loans do not let you contribute while you are paying your loan back. So, you should check the fine print on your plan before borrowing money.

There Are Fees. One thing to consider that many people do not talk about is fees. There is an amount of fees that are associated with taking out the loan. The investment company that sponsors your employer’s program will not do this for free. While most plans’ fees are not much in the grand scheme of the loan, it does cost an investment company something to issue the money, track payments, and comply with government regulations. So, you can expect to pay fees to set up a loan.

Leaving Your Job. If you leave your job, whether you quit or you are fired, before the 401k loan is completely repaid, you only have 60 days to repay the entire loan before the IRS considers it a regular withdraw and not a loan. An early withdraw from the plan will be hit with a lot of penalties and taxes that can further erode your return. If you withdraw your money before the age of 59 ½, you will be faced with a 10% penalty. That penalty is on top of the tax that you would owe the government as well because money in a 401k is used with pre-tax dollars and hasn’t been taxed yet. All of the amount of the loan outstanding would then be considered ordinary income and taxed as such. So, if the loan is large enough, you could even find yourself in a brand new tax bracket. Taxes and penalty could quickly eat up almost half of your money.

Last Resort. Taking a loan against your retirement plan should only be used as an option of last resort. There are so many other options available. You might want to consider borrowing from family members, asking the bank for a loan instead, consider peer-to-peer lending online, sell stuff on eBay and Half.com, or even take a second job in order to raise the money you need. Any of these options would probably make better choices than taking the money from your retirement. A loan against your 401k plan should not be taken lightly or used for small purchases.

Almost 97% of 401k retirement plans in a recent Hewitt Associates study had provisions in the plan that allowed their workers to borrow from their 401k retirement plans. But, just because you can, does not mean that you should do it. Loans from your retirement funds should be used as a last resort when all other options have been exhausted. The consequences of a poorly timed and haphazard 401k loan can haunt you all the way into your Golden Years of retirement.

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{ 2 comments… read them below or add one }

John June 17, 2010 at 11:23 am

Taking out a 401-k loan might be the only option people have if they are backed into a corner.

jason June 17, 2010 at 4:40 pm

i think its a bad idea to borrow against your future

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