The Pros and Cons of Borrowing from a 401(k)

Recently I have been considering of borrowing around $2,000 from my 401(k) to jump-start my financial coaching business. Honestly, I’m just being impatient but that’s a millennial for you. We all probably work with someone who is paying back a 401(k) loan. Fidelity found that 22% of account holders still have an outstanding loan balance; this was a 2% increase from the past year. In the past I preached that no one should borrow from his or her nest egg unless it’s a last resort. I ended up researching more into 401(k) loans and hence here I am blogging about the subject.

This post is exploring the pros and cons of borrowing from your 401(k). Please keep in mind that this is just for 401(k) accounts. If you have a 403(b), SEP IRA, IRA, Roth IRA or any other qualified retirement plan I strongly suggest ignoring this information as the rules may differ. Now that I have that disclaimer put out, it’s time to dig into the pros and cons of borrowing from your 401(k).


Cons

Losing Momentum

The con with long term impact is the momentum that is lost by taking money out. By taking money out of your account, lets say an individual is borrowing $1,000, that is $1,000 of momentum being delayed. By momentum I refer to the ROI on that cash that would be invested in the market and instead is being withdrawn. It’s difficult to calculate how much will be lost over the years of the account since no one can predict the market. However, it’s safe to say it will have a long-term affect on your nest egg. If the loan is repaid within a year or shorter the ramifications will be less dramatic and of course the longer the money is out the effect will be larger.

Another loss of momentum is over the repayment of the loan. When the 401(k) account is being paid back the amount will pay to get the account to where it was. That comes down to the total invested amount is playing catching up for the next year or two. The account will not be growing until the loan balance has been satisfied.

Job Security

A 2016 Gallup report found that 21% of millennials have changed their jobs within the past year. Also, 60% of millennials said they are open to the prospect of a new job. So it’s vital that I go over what happens to a 401(k) loan when you leave a job by choice or if you’re kicked out the door. Spoiler alert, when this happens reality will set in quick.

For this example we have John Constantine who borrowed $3,000 from his 401(k) so he can continue to fight demons. He decides to leave his job a year later and still owes $1,800. At that moment he has two options:

  1. Pay back the loan within 60 days
  2. Not pay back the loan

Option #1 will depend solely on if an individual can obtain the cash within 60 days. Obviously, the individual will have to gather up the cash one way or another to payback the loan or default. Option #2 is keeping the cash, which I can imagine is the more common choice. Not everyone will have the cash on hand so it’s not too surprising. However, when you keep the cash the IRS will view this loan as an early and taxable distribution. The individual will be hit with a 10% penalty and the cash will be taxed. Other additional taxes or penalties may hit as well.

Double Taxation

Borrowing from a 401(k) account will end up in double taxation of the interest. The money is taxed first when you earn it. The money is taxed again when you withdraw it from your retirement account. Simple as that folks.

There are other cons such as less take-home pay and a few other points but the above three have the biggest effect short and long term. Now time for the pros of borrowing from the 401(k).


Pros

Lower Interest Rate

Compared to other loan options the interest rate from the 401(k) can be significantly lower. Interest rates will of course be lower than same-day loans or credit card interest rates. An additional benefit is the interest money is being paid back into your account. Though the account will lose momentum as previously discussed, it can be a better option than paying interest money into a bank.

To serve as an example for interest rates I researched my own account with Fidelity and the interest rate is 5% to borrow $2,000. To use $2,000 on a credit card or loan can cost a few extra hundred bucks over the life of the loan.

Easy Access

Depending on the borrowing amount, the access to funds can be taken without question. With my Fidelity account I am able to borrow $5,000 max with no questions or reasoning behind my purpose. This option is a winner for individuals who have low credit and aren’t able to qualify for other loans. Other individuals who need money that won’t be considered a financial hardship can benefit from this pro. Best practice tip is to consult with the HR department about the max that can be borrowed before being considered a financial hardship.


Bottom Line

Reality of the matter at hand is a 401(k) loan is a risky solution and should be well planned out. The negatives do seem to outweigh the advantages. It’s similar to treat this option as a last resort and after exhausting all other options. All situations will not be the same and therefore the answer is something that only you or finance professional should decide upon.

Please comment with any of your own personal experiences when it comes to 401(k) loans or if you have any questions. Until next time neighbors, stay woke!

 

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