You’re sitting on a pile of cash… and you really need that money now. You’re struggling with debt, having a hard time making ends meet, and that 401(k) money is just sitting there, locked away for the next 20 (or 30 or 40) years.
At first glance, it makes sense to tap into that stash because you need money today. But look again, because that could be one of the worst financial mistakes you’ll ever make. In fact, it could totally derail your retirement – and leave you short of money when you need it most.
Think about it: Imagine what it will be like to worry about bills when you’re 75 or 80, and you can’t get a job… or a second job… or a side gig. The whole point of your 401(k) is to make sure that you’ll have enough money to live comfortably when you’re older, and pulling the money out now – for any reason – defeats that purpose.
Not convinced? Here are 7 hardcore reasons to never borrow from your 401(k).
- Loan Fees: Most 401(k) plans charge loan origination fees of at least $75 no matter how much you borrow. So if you borrow $1,000, you automatically take a 7.5% loss on the spot. On top of that, some plans also charge ongoing administration and loan servicing fees – and all of them increase your losses.
- Lost contributions: Some plans don’t allow you to put money into your 401(k) plan while you have an outstanding loan, so you could miss out on years worth of contributions – and that will substantially decrease your future nest egg and increase your tax bill (making contributions lowers your tax bill). And even if your plan lets you both pay back the loan and make current contributions, most people can’t afford to do both.
According to Fidelity Investments, 20% of people lower their contributions in the first year after borrowing money from their 401(k) account… and 15% stop making any contributions at all within 5 years of taking a loan.
- Less take-home pay: When it comes to making loan payments, most 401(k) plans require automatic payroll deductions starting with the very next pay period after you borrow the money. Depending on how much you borrowed, that amount could be more than your contributions were, lowering your paycheck even further. Plus, loan payments are NOT tax-deferred, so your payroll taxes will be higher… and your paycheck even smaller. And if you’re already having a hard time making ends meet, things just got worse.
- Capital losses: When you borrow money from your 401(k), the plan administrator will sell off some of your investments to give you the cash. Those shares will be repurchased as you pay back the loan. And because (generally speaking) share prices tend to tick up over time, you’ll pay more per share to get them back… essentially “selling low, buying high.”
- Lost compounding: This goes along with the last point – you’ll lose all the potential gains and growth of your investments by pulling money out of your 401(k). Even if you pay all of the money back on time and with interest, you’ll still lose out on that compounding power. That loss – especially if you stop contributing during the payback period – could translate into as much as $600 a month less in retirement income (depending on the unique factors surrounding your loan).
- Defaults and taxes: If you don’t pay your entire loan back within 5 years (loans for home purchases may allow longer payback times), it counts as a default. Here, a default means an early distribution, which comes with an automatic 10% early withdrawal penalty on top of regular income taxes on the entire unpaid balance. Plus, in some cases, a default on a 401(k) loan can lock you out of that employer’s plan for good.
- Added risk of lump-sum payback: If you leave your job for any reason, including getting laid off or fired, you have to pay back the entire loan balance all at once. Now, you have some time to do this, thanks to the new tax law. Under the old rules, you had 60 days from departure to pay your loan back in full. That time period has been extended to October 15 of the year after the year you lose or leave your job (which coincides with the due date of a federal tax return extension). And while some employers will let you continue to make regular loan payments, but most require a lump-sum payback of the full amount.
Bottom line: Taking a 401(k) loan is a bad financial move. Find some other way to come up with the money. Your future self will be forever grateful that you did.