Looking at your 401(k) statement is like being a kid in a candy shop for some people. All that money sitting in an account with your name on it! However, there are risks to taking a loan against your 401(k) account.
A loan from your 401(k) could very easily become the single most expensive loan you’ve ever had in your life—even if you remember when credit cards and mortgages were at 20% or higher. It’s never a good idea. Wealth Advisor’s recent article, “Why You Shouldn't Take A 401(k) Loan,” lists some of the reasons why.
Many people who borrow from their 401(k)s wind up lowering or completely stopping their contributions while they’re paying back the loans. This can mean the loss of 401(k) matching contributions when their contribution rates fall below the maximum matched percentage.
Most people thinking about changing jobs don't know that their outstanding 401(k) loan balance becomes due when they leave their employer. Whether a job change is voluntary or involuntary, who among us has the financial resources available to pay back a 401(k) loan right away if we leave our employer? As a result, many individuals default.
However, the new tax law gives a little cushion and you have until your tax return due date the next year. Plan balances that leave 401(k) plans due to loan defaults are rarely ever made up. That makes it less likely that loan defaulters will build sufficient retirement savings.
When you take a loan, it becomes one of your investments in your 401(k) plan account. If you were to take a $10,000 loan for five years at a 6% interest rate, that portion of your 401(k) balance will earn a 6% return for five years.
However, if your loan balance had been invested in one of the other investment options in your plan, you may have earned a lot more. Instead, look into taking a home equity loan first because interest on those loans is tax-deductible.
Easy availability of a 401(k) loan can frequently make a bad financial situation worse. It can push you into bankruptcy and/or result in the loss of your home.
Need another reason not to take a 401(k) loan? The interest you pay on any 401(k) loan is double-taxed. Since loan payments are made on an after-tax basis, interest on each payroll loan payment is taxed first, then taxed for a second time when it is paid out to you as a distribution at retirement.
Overall, the 401(k) loan is a lose-lose proposition for now and for the future.
Reference: Wealth Advisor (February 4, 2019) “Why You Shouldn't Take A 401(k) Loan”