Most 401(k) plans allow you to borrow up to half your vested balance or $50,000, whichever is lower for up to five years without triggering any taxes or penalties. But here are reasons you should never contemplate that option:
- You miss out on growth, big time: The value of a portfolio invested in stocks and bonds rises for more years than it falls. But when you borrow money from your 401(k), those stocks and bonds that you own in your 401(k) get sold when the money is withdrawn. Compound interest now works in reverse for you, putting a gigantic dent in your eventual 401(k) balance.
- You might have to payback the loan at the most inopportune time: If you change jobs or get laid off when you have a loan outstanding, the entire borrowed amount becomes due instantly or else it is considered an early withdrawal which is then subject to taxes and a 10% early withdrawal penalty.
- You lose out on free money: Some plans do not allow new contributions into your 401(k) until the loan is paid off. So, if your employer matches your contributions, you don’t get that match.
There is also this argument that you are paying taxes twice but that is a weak one and I’ll explain why. Say you need $50,000 and you have two options:
- You can borrow money from your 401(k) but that money is pre-tax money. You then pay back that loan from your paycheck but that paycheck amount is post tax money. And you are paying the loan off with that money. At retirement though, you’ll pay tax on that money again when you withdraw from your 401(k) so in theory, you paid taxes twice which is technically true.
- But then what is the alternative? You need the money and you don’t have any surplus cash so instead of borrowing from a 401(k), you borrow from a bank. Your 401(k) is left alone to keep growing. But the loan that you’ll pay back to the bank is still from your paycheck after all taxes are paid.
Both cases are sort of similar if you consider opportunity costs. In the first case, the opportunity cost is yours to suffer as the loan money you took out from your 401(k) is not participating in the markets.
In the second case, the bank suffers the opportunity cost but then the bank is not going to loan you the money for free.
So the opportunity cost penalty exists in both cases but that cost is worse with 401(k)s due to the other factors that get tagged along.
So try not to find yourself in a need to borrow by keeping healthy emergency reserves and if you must borrow, don’t do it from your 401(k).
Thank you for your time.
Cover image credit – Karolina Grabowska, Pexels