For many people, their 401k represents substantial savings. People might want to borrow from it for a variety of situations. Many finance professionals are against it. Each situation is different.
Some 401ks don’t allow loans. Many have hardship provisions in their charter. A quarter of people eventually make the raid on their retirement savings account.
Rules are constantly changing, but the government allows 50% of the funds, up to a limit of 50k, borrowed for five years. This loan is tax-free and has to be repaid gradually. The interest rate is usually very low. And the interest doesn’t go to any lender; it goes to you.
Some advice professionals recommend this route because it seems like a low-interest loan. But it’s often a poor idea.
One thing that’s often missed is the poor math. You made your original contributions with pre-tax money. You’ll need to pay it back with after-tax money. Therefore, paying back your loan will require significantly more capital.
You’ll indeed be paying yourself interest. But often, these returns will be a pittance compared to what your retirement savings could have earned in the stock market. Taking into account compound interest, your lost investment returns will be substantial.
If Unable to Pay Loan
The tax situation gets worse if you’re unable to pay the loan. The IRS will reclassify the loan as a withdrawal. You could be subject to taxation at your current income rate. There will also be an early withdrawal penalty. Often this is a punch to the gut to a struggling borrower.
Lose Last Financial Cushion
Let’s say times are not desperate (say you’re investing in a business). Your 401k is often the last possible asset to prevent financial disaster.
Poor Personal Finance
Often, the situation can be solved if you change your financial practices. Borrowing against your financial future is not smart if it’s because you’re spending too much on restaurants. This is especially true if you’re middle-aged because you’ll have less time to replace those savings. Older borrowers won’t be able to take advantage of compound interest as much.
Borrowing against your 401k can seem smart. There are some advantages. But often, it’s a poor financial choice. Tread carefully.