Like many folks working in Corporate America, the lynch pin of my retirement planning involves a company sponsored 401k. My company matches 5% for the first 4% that I ante up, so I happily contribute that amount and take the free money. The total amount in my account has swelled to over $40,000, and as long as the stock market doesn’t totally mess itself and I continue working for this company– that amount should continue to grow steadily.
I also had a 401k at my last company many years ago, and when I switched jobs– I rolled it over into an IRA (which I still have). However, I took a major hit in the process because I had an outstanding loan against the 401k, and left the job before I had finished making payments. Of course, my retirement would be in much better shape today had I never taken out that loan. We used the loan to help us through a really tough financial period, but I was young and didn’t really understand the impact of what we were doing. In general, taking out loans against your 401k is NOT a good idea. But it is easy to see why people do it:
The Good:
You don’t have to deal with a bank or get your credit checked when you get a loan against your 401k. You earned the money in your retirement fund, so you are effectively borrowing money from your future self. Yes, you do have to pay a low interest rate (usually pretty close to prime), but you are actually paying the interest to yourself. Most plans let you choose your loan repayment term, and you can extend payments for as many as five years. Your loan payments will be automatically withdrawn from your paycheck, along with your taxes, insurance premiums, etc.
The Bad:
Taking out a loan against your 401k will cost you money in the long run. By taking this money out, you lose out on any potential returns on your investment accounts. Even worse, you certainly lose out on some of the tax benefits of having a 401k in the first place. Contributions to your 401k are normally made before taxes (that is the whole appeal). However, the loan repayments that are automatically deducted from your paycheck are actually made AFTER taxes. This means that as you make these payments (and the corresponding interest) you are completely eliminating the tax benefits that you originally received, and more. I should also mention that most 401k loans also charge a fee for taking out a loan, so this is an additional charge that is taken off the top.
Note: I am going to stop short of saying that you are “double-taxed” here, because you really aren’t. If you didn’t borrow from your 401k, you certainly wouldn’t find a loan from a bank somewhere else that would allow you to pay with before-tax dollars.
The Ugly:
The true ugliness of 401k loans surrounds the exact situation that happened to me. If you leave a job (willingly or unwillingly) before you finish making payments on your loan, you generally have 60 days to pay the balance, or you will default. You typically can’t roll a 401k loan over to a new company. Defaulting on the loan, means that the outstanding balance counts as earned income for this year, and is taxable. But that isn’t all. It also means that you are withdrawing the money before you are 59 & 1/2, which adds another 10% penalty. Ouch!
Because of the penalties, 401k loans have been known to force people to stay at jobs that they aren’t happy with. Perhaps that is why most companies are willing to sponsor these loans!
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This article originally appeared in April 2012
401k Loans : The Good, The Bad, and the Ugly is a post from: See Debt Run