Things seem to be getting more expensive each day. The cost of living is going through the roof. The prices for food, lumber and other items seem to become more exorbitant by the hour. It’s hard times like these where we must find some money to stay on top of our bills, needs, and other expenses. Your 401(k) may seem like a good solution.
You may have a 401(k) you’re thinking about loaning against to supplement your income. However, before you start delving more deeply into that idea, understand this isn’t advisable at all. There are many reasons, but the largest one is that you are borrowing against your future.
Why 401(k) Loans Look Desirable
It’s easy to see why you might want to do this. After all, the prospect is attractive:
- You can borrow up to ½ of the available funds, and it’s tax-free.
- The interest rates are low, and your account receives the interest rather than some bank or predatory lender.
- Another plus to taking out a loan on your 401(k) is that it doesn’t require a credit check, and it won’t appear on your credit report. Therefore, it’s not going to affect your future ability to take out a loan from a bank, even if you do default.
The Bare Bones of a Bad Idea
But, you must repay this loan with after-tax dollars, and you could lose investment earnings because the money isn’t there. If you lose your job in the interim, you will have to repay the loan faster and often by your next tax return due date.
Any default means you still owe money. This turns the loan into a withdrawal which may come with additional penalties on your tax return.
The Devil Is in the Details
While interest rates are desirably low with the bonus of paying yourself interest, it may be appealing to take out a loan. Besides, you’re just borrowing from yourself, right? All this sounds good and desirable, but there are several reasons why you shouldn’t borrow against your precious 401(k).
Repayment Exceeds Initial Contributions
Repaying your loan will be worth less than your initial contributions to the fund. So, even though you’re borrowing from yourself, you’re paying the money back after taxes. The money you initially contributed came from pre-tax dollars. This means the repaid money will be worth less than what you first put in.
For instance, those sitting in the 24% tax bracket will get $0.76 of every dollar that goes into repaying the loan. You will have to work more to make it equal just as much.
Interest Rate vs. Opportunity Costs
Far too many people mistake the interest on a 401(k) loan as somehow free because they’re paying it to themselves. However, there is an opportunity cost involved with these loans you may consider. Because a portion of your contributions won’t be in the account, you will lose out on returns.
For instance, if the total return was 8%, the cost of the loan is also going to be 8% because the money wasn’t in the 401(k) to collect it. That makes the loan cost far more than going to a bank for a personal loan.
Provisions May Compound Problems
Also, depending on your 401(k) company rules, you may not be able to make any further contributions until you pay off the debt. Even without the stipulation, you may not be able to contribute because of your financial issues.
Either way, you’re depriving yourself of a sustainable future because you will severely limit the potential for accrual. The gap of what you’re missing can also lead to missed matches from your employer.
Future Financial Hardships
What’s more, none of this accounts for a further deterioration of your finances. In these times, it seems easy for things to spiral downward quickly. Sure, you may have work and other sorts of income now keeping you afloat right now. But what if an undue hardship occurs? If you can’t repay the loan, this will make your financial situation worse.
When you default, the remainder of what you owe converts into a withdrawal. Unless you qualify for a hardship withdrawal, you will subject the outstanding balance to your current income tax rate. Hardship withdrawals are emergency payments for things like tuition, mortgage, or medical expenses.
Plus, you might incur other penalties as well. People under 59½ years old will have to pay an additional 10% penalty for early withdrawal on the amount borrowed. While you may not have to pay taxes on the loan, this will reduce the amount and value of your initial contributions.
Quitting or Losing Your Job
If you lose your job or quit, you will have to repay your loan much faster too. This is often by the time of your next federal tax return if that date is within 60 days after your departure. Having a loan through a 401(k) may end up tying you to a job you no longer enjoy or force you to pass up a better job opportunity.
Nest Egg Depletion
Plus, borrowing against your 401(k) removes your capacity to handle any unforeseen future disasters. Sure, you might be in serious need of some money right now. But what if something happens like an accident, death, or other major emergencies that require additional immediate money you don’t have? You will put yourself into an even more difficult situation financially.
It’s better to find alternative solutions to your financial woes than borrow against your 401(k). If you have a good enough credit score to get a personal loan or take out a line of credit against your home equity, which will be somewhat better depending on the circumstances. Even tapping into your emergency savings or using your HSA savings for your medical expenses are more ideal.
Evaluate Your Budget
First, look over your monthly budget and figure out ways to cut corners. This will include looking at grocery bills and taking a hard, honest view of your needs and what you buy to support your expensive tastes or lifestyle.
For instance, if you’re buying shampoo and conditioner that costs $50 every two weeks for your luscious long hair, either hunt down a store with a discount or go with a less expensive one. Do you eat out a lot? Do you order delivery food frequently? Stop this and start cooking at home; you’ll save hundreds this way.
Sell Unused and Unwanted Junk
Then, go through your house and peruse all your old stuff like CDs, clothing, bicycles, and other items you no longer need or use. If these are in good condition, you can sell them at an online marketplace, like eBay or Poshmark.
Using Your 401(k) for a Loan
Many financial advisors tell people not to take out a loan against their 401(k). Yet about ¼ of the people holding a 401(k) will do this anyway. While half of these people will repay the loan without issue, the other half almost always end up in a far more disastrous situation.
If you are absolute without any other recourse to obtain money, confer with a financial counselor about taking a loan out against your 401(k). But understand this goes against every principle, rule, and guideline for long-term investing. This kind of loan should be your last-ditch nuke-button option when all other forms have failed.
No one can see the future. Taking out a loan will only satisfy your present short-term financial troubles; it’s not a long-term solution by any means. If you want to retire the way you want, leave your 401(k) alone.
The whole reason why you have this is to ensure your comfort during retirement. Borrowing against your future is not a financially sound or solvent idea. You may end up in a worse position than before you took out the loan. Therefore, it’s imperative to look for other avenues and use a 401(k) loan for life-and-death emergencies.