3 Reasons Why You Should Not Borrow from Your 401(k) Plan

3 Reasons Why You Should Not Borrow from Your 401(k) Plan

A friend at work is thinking about borrowing from his 401(k) 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 401(k). 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.

nest egg

Photo by Angelray via Flickr

Why Borrowing from Your 401(k) is A Bad Idea

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 will be taxed on the amount owed at your marginal tax rate (or higher).
  • You will be assess a 10% early withdrawal penalty.
  • You will 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 401(k) while there is an outstanding loan. This could hurt you significantly in three major ways:

  • You lose the ability to add new money to the plan, and the growth potential of that money with it.
  • You lose free money in the form of company’s matching contributions (if your company offers this).
  • You lose the ability to deduct your 401(k) contributions from your taxable income to reduce your taxes.

For example, if you regularly contribute $500 a month and your company matching contribution is $100, over the course of one year, you will have $6,000 less in retirement savings, lose $1,200 in free money, and give up $2,520 in tax deduction (assuming a total combined tax rate of 35%).

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.

What About Double Taxation?

You may have read somewhere that when you contribute to your 401(k), 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. The example usually goes something like this:

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).

401k loan double taxation is actually a myth. It doesn’t matter where you borrow the money from, you will have to pay back the loan with after-tax dollars. Here are some good articles that help dispel the myth:

Better Ways To Get Cash

As you can see, the price for borrowing from your 401(k) 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.
  • Borrow money from peer-to-peer lending networks.
  • Cash out mortgage refinancing.
  • Borrowing against a cash-value life insurance policy.

Have you considered borrowing from 401(k) before? What did you do? Why? Please share your story.

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20 thoughts on “3 Reasons Why You Should Not Borrow from Your 401(k) Plan”

  1. 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.

  2. 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.

  3. 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.

  4. 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.

  5. 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.

  6. 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.

  7. 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.

  8. 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.

  9. 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.

  10. 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?

  11. 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?

  12. Whatever you do never ever borrow from your 401k plan at work. I did in 1997 to finance a move to Alaska. It was the worse mistake I ever made in my life. Today I am retired living on SS and a very small pension check. There are no jobs where I live even if I wanted one. I will be 66 soon and no one will hire you at that age no matter how much experience you have. Now that I should be in a stress free time in the twilight of my life I am having to sell my car and I just moved into a one bedroom with no w/d. I worked 51 years in a row without ever being out of work. I spent my money always thinking I’d have that next paycheck in two weeks. Now I depend on the government to live. If I could go back in time boy would I have done things different. You have to make money in your 20’s and 30’s and 40’s and 50’s. After that its a crap shoot. If only I could go back in time.

  13. I am thinking of barrowing from my 401K to pay off a credit card. Since the market is not gaining and I am actually losing money each quarter is this a good idea? The amount barrowed is around $7,000.00 My company does not match.

    • @Nick – The answer depends on a few things: (1) and this is the most important one, if you do this, are you planning to change how you use your credit card, e.g., are you going to put more charges on it? If the answer is yes, then you might as well not do this because you’ll end up depleting your 401k and put more debt onto the credit card, (2) you’ll have to repay the 401k back, will you be able to live off the lower amount from your paychecks for the next 36 months?, (3) how stable is your job? If there’s any chance that your job will disappear, this is a risky move because you have to repay everything all at once.

      Good luck.

  14. The double taxation is a total myth. Probably perpetrated by well-meaning TV and Radio financial ‘experts’. No matter where you borrow money from (tax-shelter, bank, Mom, brother, Credit Union… etc.) you pay it back with taxed dollars. People focus on the borrowed money, when you should look at the product you buy with the borrowed money. Example: borrow $1000 to buy a refrigerator – or for that matter pay cash for it. Either way you pay for it with taxed dollars. By using a tax-sheltered account to borrow from you still pay the tax on the dollars you use to but the fridge – not on the money you borrowed.

    Double 401(k) taxation is a farce -pure and simple. Anyone who can do math should be able to figure it out! Shame on Suzie Ormond!!!

  15. I cashed out my 401K more than 5 years ago in order to pay off grad school, buy a ring, and get married. That was before I learned about money. I now joke with my wife that her ring and honeymoon would have been much smaller and delayed if I had known about investing.

  16. I quit my job over a month ago and have a loan of about $1200 left to pay on. Of course I dont have the money to pay this loan off. I haven’t heard from the plan administrator about the balance due. I have $22K in the account. I’ve been interviewing but don’t think I’ll meet the 60 day deadline. Is it best to take the penalty and invest the money elsewhere until I find a job?

  17. The worst case scenario happened to a friend of mine – he took his 401K money – pretty much all of it and invested it in a business that was supposed to be a big money maker – but after they ordered and paid for the manufacturing machines, and before delivery, the company that made the machines went bankrupt. Getting back 10 cents on the dollar in bankruptcy court some time later. 15 years later he is 75 years old and still working, with no 401K… Remember – small businesses have a very high failure rate – and success or failure is not always dependent on your skills and abilities, lots of good people lose money every day on business deals that seemed good at the time.

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