Should I Borrow From My 401k Plan?
A friend at work is thinking about borrowing from his 401k plan to fund his business start-up. He mentioned it to me and I told him that it’s a terrible idea to borrow from 401k. It may sound appealing at first — i.e., fast loan application, easy to qualify, and you pay the interest to yourself. However, it’s not that pretty if you look deeply into it.
Photo by Angelray via Flickr
Why Borrowing From Your 401k Is A Bad Idea
Paying The Loan With After-Tax Dollars
When you contribute to your 401k, you are doing so with pre-tax dollars. However, when you are paying back the loan, you are doing so with after-tax dollars and you’ll get taxed again when you finally withdraw the amount during your retirement.
For example, if you borrow $10,000 from your 401k plan and your marginal tax rate is 25%, you’ll have to earn $13,333 to pay back the entire loan (before factoring in the interest).
Updated 7/30/2008: After reading two other bloggers’ articles about 401k loan double taxation myth, I now believe that double taxation is not a real factor. However, other factors below are still valid. Here are their articles:
- Double Taxation and the Real Reasons 401(k) Loans Are Bad at My Money Blog
- 401k Loan Double Taxation Myth at the Financial Buff
Early Pay Back Risk
If you leave your job for any reason — i.e., you are fired — you are required to pay back the entire loan balance in as little as 30 days. If you are unable to pay back:
- You’ll be taxed on the amount owed at your marginal tax rate (or higher).
- You’ll be assess a 10% early-withdrawal penalty.
- You’ll lose the ability to put that money back to work for you as retirement money, leaving yourself less to retire with.
For example, if you owe a balance of $10,000 when you leave your job and your marginal tax rate is 25%, you’ll have to pay $2,500 in taxes and $1,000 in early-withdrawal penalty. Plus, your retirement fund will be permanently lowered by $10,000.
Contribution Risk
Some plan does not allow you to contribute new money to your 401k while there’s a loan outstanding. This could hurt you significantly in three major ways:
- You’ll lose the ability to add new money to the plan, and the growth potential of that money with it.
- If your company offers a matching contribution, you’ll be leaving free money on the table.
- You’ll lose the ability to deduct your 401k contributions from your taxes.
For example, if you regularly contribute $500 a month and your company matching contribution is $200 per month, over the course of one year, you’ll have $6,000 less in retirement savings, lose $2,400 in free money, and give up $1,500 in tax deduction.
Loss of Bankruptcy Protection
Lastly, your retirement savings are generally sheltered if you file for bankruptcy. However, the amount you borrowed is no longer protected. Basically, you could lose it all.
Better Ways To Get Cash
As you can see, the price for borrowing from your 401k could be very steep. But what are some of the options you have if you need the money? Here are a few ideas:
- Reduce your expenses — This is probably the easiest way to free up some money. Are there any recurring expenses that you could reduce? Are there any planned expenses, such as a vacation, that you could defer? Are you practicing frugality?
- Increase your income — Looks for things that you could do to generate income. There are many ways to do this ranging building alternative income streams, working a second job and selling your possessions.
- Take out a home equity loan, or a home equity line of credit (HELOC)
- Mortgage Refinancing
- Borrowing against a cash-value life insurance policy
Have you considered borrowing from 401k before? What did you do? Why? Please share your story.
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Another way this person can get cash is to apply for a loan at Prosper or Lending Club, instead of using the 401k.
I recommended Small Business Administration to him as a place to start looking for small business loan and grants.
Wow, I can’t imagine a worse way to finance a business than using your 401K. I also don’t generally think it is a good idea to start a business with a large chunk of money. I rarely find more than $10k is necessary, and often you can start with much less. We started all our businesses (five in various industries) on $500 or less. All have been successful and made money in the first year.
This topic alone is deep enough to write a series of articles. Three key advantages of starting a business on a shoestring:
-It forces you to innovate.
-It minimizes the risk if the business goes under.
-It forces you to focus on the customer and sales, not on office furniture and equipment. The first makes you money, the second burns through your cash.
I think there should be a rule that eliminates the ability to take the money out unless you have a hardship exception. Just so many reasons to NOT do it…
The thing about starting a business is there is great risk and potential great reward. The only problem is when you are on the start up side you think you are invincible and your product is going to be an immediate hit. Usually not the case.
I borrowed against my 401(k) for some extra spending money. Ironically enough, I have spent less than I borrowed, yet I can’t pay back the loan early without a penalty. So, I invested the money, which has turned out to be a windfall, and made even more money than I first took out. I’ll finally have the loan paid off in July (took out a two year loan) and will be extremely happy to have all that money back in my pocket (or really redirected to a Roth IRA) rather than paying for a loan that I never should have taken in the first place.
I would only advise an early 401(k) distribution or loan for a catastrophic need. It is an extraordinarily bad idea to fund a business venture with retirement savings. The risk involved with a new business way outweighs the potential upside, even if this person feels that his endeavor is a “sure thing.” Trust me – I’ve seen several new business owners go through heart-breaking bankruptcies. It’s just a bad, bad idea.
On the one hand it doesn’t surprise me a bit that someone would consider a loan from 401K as a good place to look for venture capital. On the other hand, I’m so involved in personal finance that it just seems nuts to me. However, the fact of the matter is that many people consider any large stockpile of cash as a place to pull funds from when they have an emergency or idea. It’s just a good thing that he talked to you first.
Playing the devil’s advocate though; It could end up being the best thing ever for him. It’s certainly a gamble and one I wouldn’t take, but who am I to judge.
I did it when quitting a good job due to burnout. Sure, I had some money to tide me over, but I ended up declaring bankruptcy anyway down the line. Both huge mistakes. I asked people for advice at that time, but the people I chose were either not invested in really helping me, or were actually invested in me making these mistakes. The taxes were a killer, and I am just now truly recovering. Yes, I had a hardship, but not a catastrophic one, and I should have found other ways to survive.
However, I think this period in my life has made me a better financial judge, and I still appreciate having the things I do now. My husband and I make under 40K a year, and we live on 30K, saving the rest for the future.
This would be one case where I’d look at Prosper.com
Your 401k is not always the best place to put your money. If you could instead save that money and use it to start a business you have the potential for much higher returns. However, most people wont realistically do that, and for them the 401k is one of the better places to be putting your money. And, as you advised, if you’ve already been putting you money in your 401k, it’s usually a bad idea to borrow from it.
I don’t want the government to say that you can’t withdrawal money from your 401(k), but it rarely is a good choice. There are so many better ways to get a quick loan.
For the people who say investing in a 401k is a bad investment you could be right or wrong but only in one manner… What is the company match? For people who think the free money thing is a scam they are incorrect. If you put 100 dollars in a bank for a year and earn 5 percent interest ( and no one will earn that in a bank account) you will earn 5 dollars. If you contribute 100 dollars to your 401k and you company matches 100 percent you now have 200 without even considering the investment.. That’s a 100 percent return… Even if you were insanely aggressive and went all stocks even a market like 2008 you would have maybe a 40 percent loss.. You are still ahead of just putting it in the bank… And if you were smart you spread it out and lost less then 40 percent so make out even better… and if you were ultra conservative and had it all in a stable fund you have above 200 dollars.. there is really no way if you get match you can beat the ease of gaining free money.
I would be interested in hearing some opinions on my situation. I am going to school at night, I work full-time during the day, and I am in a deep financial mess. I have a 401K plan that I have now had for 20 years. I was considering taking out a loan. My salary dropped almost $10,000 last year. The recent recession has hurt me more than I thought, and I already have an equity loan that I am paying on. My daughter is starting her second year at college and there are supplies(computer, etc) that I am trying to get. I have back taxes that I need to pay and on top of that is my mortgage and other bills. I have been creative in the way I stay afloat these days, but I see myself sinking in the near future if I dont try something soon. Would using a credit card(with 9.9% interest) be a better solution to paying some bills as opposed to taking a loan from my 401k?
Does anyone ever consider using a 401K loan to make an deductible (or non-deductible) IRA contribution?
Here’s an example: You have a $10,000 balance in your 401K plan, and $6,000 balance in a deductible IRA.
Your total retirement savings @ this point is $16,000.00
If you take a $5,000.00 loan from the 401K plan, and use that to make a deductible IRA contribution.
Your 401K is now $5,000.00 but your IRA is now $11,000.00 leaving you with $16,000.00 of retirement assets.
You (hopefully) get a tax deduction you otherwise would not have had; you have more choice over where to invest the cash; and if you can still keep up the 401K contributions as you pay down the loan, your balance increases that much more quickly.
Any comments on this?