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 not contemplate that option:
- You miss out on big time growth: 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when you borrow money from your 401(k), those stocks and bonds that you own in your 401(k) get sold when the money is withdrawn.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 pay back the loan at the most inopportune time: If you change jobs or get laid off when you have a loan outstanding, the entire loan balance 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: Most plans do not allow new contributions into your 401(k) until the loan is paid off. So, if your employer matches your contributions, you do not 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 money is after-tax 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 on growing. But the loan that you’ll pay back to the bank is still from your paycheck which is after-tax money.
So, both cases are 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.
The opportunity cost penalty hence exists in both cases, but that cost is worse with 401(k)s due to the other factors that get tagged along.
So, the best solution is to try to not find yourself in a situation where you need to borrow by setting aside 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