How 401k Loans Break Your Nest Egg

401k loans

401k loans are one of the benefits that Jean Chatzky bullets in her article about taking advantage of an employer's 401k match.

She states that "most plans allow you to borrow from your 401(k), then pay the amount back to yourself with interest".

Let's see why many consider borrowing from 401k plans a great option for emergency cash...and why we think it's one of the worst.

Advantages

  • There is no credit check which means the process of getting this loan will not affect your fico score. You will be approved if there are sufficient funds.
  • The interest rate is typically low and already set by the plan.
  • You can pay back the loan with interest.
  • It's convenient and pretty painless. Some plans require filling out a short form or just a phone call.

If you consider the bullets above, it seem to fit the mold of sound 401k advice.

My old boss quoted most of these advantages when we discussed him taking out a loan against his 401k. The market was low and he wanted to do some work to his house. But, he didn't know the real story as to why I think 401k loans are a bad idea.

Disadvantages

  • You can only borrow a limited amount. You are allowed to access up to 50% of your vested account balance or $50,000, whichever is less.
  • You incur the lost opportunity cost by taking money out of the plan. Thus, that amount will not grow in value with interest, dividends, and/or capital gains. It's just like taking money out of your savings account and paying it back. Imagine the potential growth you lose over a 30 or 40 year period.
  • The interest you pay back is not tax deductible. It's a consumer loan with no tax advantages. Sorry, no tax saving tips here.
  • You must pay back the loan over a short period of time, usually a maximum of five years. If you so happen to lose your job, the full loan amount is due. Isn't that great? You are required to pay in full when you no longer have the job that gave you the means to do so. Irony.

These disadvantages don't compare to what I consider the biggest drawback with borrowing from 401k plans.

Double Taxation

Financial experts urge you to repay the loan back into your plan. This makes sense because you want to replenish the opportunity for your plan to grow at its greatest potential. When money is out of the plan, it cannot grow.

One thing people forget is that the money being paid into a 401k retirement plan is pre-taxed. Meaning, you defer paying taxes on those dollars until you receive the distributions during retirement.

The money you pay back into your plan is post-tax, dollars that are already taxed. Let's look at an example:

Say you borrowed $5000 from your 401k plan (which was funded with pre-tax dollars). You paid back the $5000 with money that has already been taxed. Taxed once.

When you hit retirement, that same $5000 will be distributed. Remember, you will pay taxes again on that $5000 because this is the nature of the plan (to defer taxes). Taxed twice!

Wouldn't it make sense to be able to pay back the loan with pre-tax dollars?

Better Yet!

If you have equity in your home, take out a home equity loan. You can deduct the interest on your taxes.

Or, take a policy loan from your whole life insurance policy and invoke the Infinite Banking strategies. You recapture the lost opportunity cost.

In case of a true emergency, you'll do what you have to do, even if it means possibly crippling your 401k plan with a 401k loan. My 401k advice? Don't invest in 401k plans unless you fully understand the advantages of disadvantages of such a vehicle.

Maybe, consider taking a 401k withdrawal. I did.

Borrowing from a 401k plan can give instant gratification. But the lasting effects could be a...taxing situation.

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