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.
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.
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:
- Double Taxation and the Real Reasons 401(k) Loans Are Bad at My Money Blog
- 401k Loan Double Taxation Myth at the Financial Buff
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.
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.