One of the features of many 401(k) plans is the ability for participants to take a loan against their balance. There are rules governing what the loans can be used for, the number of loans that can be outstanding at one time, and the percentage of your account balance that can be borrowed. Additionally there is a time limit by which these loans need to be repaid.
It is the decision of the organization sponsoring the plan whether or not to allow loans and also as to what they can be used for. Typical reasons allowed are for college expenses for your children, medical expenses, the purchase of a home, or to prevent eviction from your home.
The flexibility offered by allowing loans is often touted as one of the good features of the 401(k). However taking a loan from your 401(k) also carries some downsides. Here are 7 reasons to avoid 401(k) loans.
Leaving your job triggers repayment
If you leave your job with an outstanding loan against your 401(k) account the balance can become due and payable immediately. This applies whether you leave your job voluntarily or involuntarily via some sort of termination. While your regularly scheduled repayments are deducted from your paycheck, you will need to come up with the funds to repay the loan upon leaving your job or it will become a taxable distribution. Additionally if you are under 59 ½ a 10% penalty might also apply.
Opportunity costs in a rising market
While loan repayments do carry an interest component which you essentially pay to yourself, the interest rate might be much lower than what you might have earned on your investments in the plan during a rising stock market. Obviously this will depend upon the market conditions and how you would have invested the money. This can lead to a lower balance at retirement resulting in a lower standard of living or possibly necessitating that you work longer than you had planned.
There are fees involved
There are often fees for loan origination, administration, and maintenance which you will be responsible for paying.
Interest is not tax deductible
Even if the purpose of the loan is to purchase your principal residence interest on 401(k) loans is not tax-deductible.
No flexibility in the repayment terms
The loan payments are taken from your paycheck which all things being equal will reduce the amount of money you bring home each pay period. If you run into financial difficulty you cannot change the terms of the loan repayment.
You might be tempted to reduce your 401(k) deferrals
The fact that you now have to repay the loan from your paycheck might cause you to reduce the amount you are saving for retirement via your salary deferral to the plan.
You will have less at retirement
A loan against your 401(k) plan will result in lower nest egg at retirement. Given the difficulty many in the United States already have in accumulating a sufficient amount for retirement this only adds to the problem.
You should especially avoid 401(k) loans if:
- You are near retirement
- You feel that your job security is in jeopardy
- You are planning to leave your job in the near future
- You are already behind in saving for retirement
- You have other sources to obtain the money you need
- You feel that repaying the loan will be financial hardship
Look life happens and sometimes taking a loan from your 401(k) plan can’t be avoided. The economy has been tough for many over the past few years. However if at all possible avoid taking a 401(k) loan and rather let that money grow for your retirement. Down the road you will be glad you did.
Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Also check out our Resources page for more tools and services that you might find useful.