I had a question posed to me this week about 401k loans, and whether they were a good idea. The person said they were considering using a 401k loan to pay off some higher interest credit card debt. The rationale behind doing this was that they’d rather pay themselves interest than the credit card company, and that the interest on the 401k loan was lower as well.
In some cases taking out a 401k loan can seem to make sense, and I wasn’t quite sure what to tell this person. I felt like there might be some hidden reasons that it wasn’t the greatest plan.
After doing some research on the topic I found that many experts frown on these types of loans.
There are a variety of risks inherent in taking out 401k loans, and you can end up losing a lot of money if something goes wrong (You know what they say about that – usually whatever can go wrong, will).
Here are a few of the reasons why you should think twice about getting a 401k loan.
Reasons To Think Twice About A 401k Loan
- If something happens and you quit or get fired from your job before the loan is paid back, you will be obligated to pay it back immediately or suffer the fees and penalties associated with a 401k withdrawal. (your tax rate plus 10% penalty – up to 40% or more sometimes). Often times this is the time you can least afford to pay it back! Many plans have a 60-90 grace period to pay the loan back after you leave your job.
- The money is essentially taxed twice because you’re paying 401k loan back with after tax dollars, and then you’re paying taxes again at withdrawal at retirement.
- The money from the loan can be treated as taxable income if the loan goes into default, which may end up bumping your tax bracket up and costing you even more in taxes.
When it comes right down to it Dave Ramsey said this:
Never, ever borrow on your retirement. In an emergency like owing the IRS or facing foreclosure, you can withdraw some. You’ll still get taxed, but don’t borrow against it.
I can see how someone might be tempted to take out a 401k loan. On the surface it seems like a good deal. But when you examine the risks involved with taking one of these loans, often you’re probably better of just setting up your debt snowball and getting “gazelle intense” and just paying off the debt as quick as possible.
There are some situations where I might actually consider taking out a loan or early withdrawal, like in a situation where you may end up losing your house, but it would have to be a pretty dire situation in deed. Weight the risks involved – with the risk of not taking it out and make the best decision for your family.
What do you think about 401k loans? Do you think they’re ever a good idea? Would you or have you ever taken one out? How did it work out for you?
Links:
- Don’t borrow against retirement @ daveramsey.com
- 5 reasons its a bad idea to take out a 401k Loan
- IRS 401k rules
It’s got to be a pretty major emergency, I think, to borrow. Although if you do, you should borrow as little as possible, after exhausting other resources. I like the idea of borrowing against the 401k better than outright withdrawal, though, since you are basically paying interest to yourself with a 401k loan. With the withdrawal, you have the penalty AND the tax, and that’s money you don’t ever get back.
Mirandas last blog post..Yielding Wealth Poll: Can Barack Obama Fix The Economy?
While some of your points may be valid, the one about paying taxes on a 401K loan as taxable income is wrong. I have taken out several over the course of the years and it has never been taxed as income. It’s a loan, not a withdrawal and you are obligated to pay it back.
I also question the part about having to pay the entire loan back if you quit or get fired as that is somewhat determined by the terms of the 401K.
The biggest drawback to borrowing money against your 401K right now is that in order to get the cash, your fund has to sell your stocks and right now, with stock prices being down, you are cementing in a loss.
If you leave your stocks as they are, and wait out this downturn, you’ll find that they will balance out because they will gain in value as the market rises.
My advice to everyone regarding their 401K is to leave it alone.
The one exception would be if you have an existing loan, now would be a good time to refinance it if your fund allows you to so. Since most 401K loans are tied to prime, you can take advantage of the lower interest rates. That would actually free up some money to go into your fund.
ê¿ê
Margarets last blog post..Pictures Are Not Only Worth 1000 Words, They’re Worth SEO!
I may not have written that point about it being taxable correctly, I’ll restate it above.
It should read that if you don’t follow the repayment plan to the letter of the law and the loan goes into default, it can be treated as taxable income, thereby bumping you up a tax bracket.
If you repay it as required, that should not be an issue as it isn’t taxed until you’re in default.
As far as the having to pay it back if you quit, get laid off or are fired, I think it varies from plan to plan, but normally it is from 60-90 days to pay it back, otherwise its treated as taxable income.
I never even knew that was a practice before. Thanks for the info. It doesn’t seem practical for someone to take out the loan and things could only go wrong. It’s a huge risk/reward factor that really seems like there is no reward. There has to be better options to pay of credit card debt and ways to save money than this practice.
Craig
http://www.budgetpulse.com
I can’t imagine how bad things would have to get for me to do that. I consider that money completely off limits, emergency fund has to be drained, I would have to be working about 70 hours a week, and probably would find 0% credit cards and get in more debt before touching my retirement money.
So, if my 401K is giving me a return of -12% and the remainder of my auto loan is 8.9%, why not pay off the loan with my 401K in 12 months?
Thanks for the great tips.
– The money is essentially taxed twice
Unless you can take out a home-equity loan and use it as an itimized deduction, this is not correct. You’ll still be repaying the loan with after tax dollars and you’re just replacing money that would have been taxed at retirement anyway.
i am retired on disability small monthly income so i starteding drawing on my 401k 5 years ago. was doing ok was drading 5% and making 12% now 401k is half of what it was and not making anthing.cant live on disability alone will 401 come back or will i run out of funsd first ah have to sell my house to live on. there 1,ooos of retired people who are in trouble and will have to sell everything just to live. the goverment gave away peoples money who worked for it and gave it to people who wont but can work. once you start drawing ssi inflation catches up with you a cost o living raise doesn’t help much. my neighbor gets 545 a month if her kids didnt help she couldnt live. some people in there 20’s draw 1,000 plus nevered worked old woman worked 40 years got $390 27 years ago plus her husband deawed $400 amonth after her husband died she only gets her ss where is our bail out death
I have a $35,000 loan from my 401 account. The company just sold so I have until Dec 31, to pay it back in a lump sum or default. Do I try to get a home equity loan to pay it back or just cut my losses and move forward !!!!
I just got laid off with a 8 thousand dollar loan from my 401 K.There is no way that I can repay this amount.There is a 10 thousand dollar balance on my account.What am I to do?
If you can not repay the 8k, then the loan payment will be considered a early withdrawal. You will then have to pay 10% penalty, and then taxes on the 8k when you file taxes.
The 10k that is in the 401k should not be touched until retirement.
There are times when a 401k loan makes sense, as long as you understand all the variables in play. For example, if the following conditions are met, a 401k loan could be a reasonable approach:
1. You have existing high interest debt to pay off, or are in need of borrowing for a necessity. A good point regarding this condition is that any debt you are paying, even a non-401k loan, will be with after-tax money, so there is no “additional” penalty of getting taxed twice just because it is a 401k loan.
2. Stock prices are at reasonable levels. As Margaret said in an earlier post, you don’t want to cement in losses by taking a loan when the market is bottomed out. This is a judgement call, though, because you never really know where the bottom is until afterwards.
3. You would like to diversify your portfolio by adding some lower-risk funds. A loan to yourself should be low risk (if you have a secure job) and will likely yield better returns than stable value type funds. It’s true that you could be giving up the often significant gains found in stocks, but investments are always a trade off between risk and reward.
4. Your job is extremely likely to remain secure during the repayment period. Be careful you are not just fooling yourself into thinking your job is secure. Having to take the loan as income along with a 10% penalty can be a very costly mistake.
I think that 401k loans can be a good idea in some situations. If you have a dire emergency, such as owing money to the IRS, foreclosure, etc. it may make sense. You should only do it if you have a specific repayment strategy in place.
A 401k loan done the right way can be very rewarding. 401ks usually have very limited investing options. So using a loan to start a business or any other well thought out plan to generate cashflow maybe a great idea. Invest in yourself. Seems like the big guys are trying to discourage this because they dont get to keep their hands on your money. So they say all these things to discourage it. Also so what if you end up paying taxes on it. Do you think you will never pay taxes on it? You could just leave it there til you die and just let them have it and you will neve have to pay the tax or the penalty…So anyway, I figure what a better time for your payments to expire? Lost your job? How do you pay the other loan? Home loan…CCs? Pay 10% penalty once instead of say 6% every year for how long? Overall defaulting on a 401k loan maybe the best thing after a job loss. I think…Ive taken at least 6 now and love it!
What about for a down payment plus closing costs. My estimates were way off. So now I would need to borrow 6,000 from 401k. So it’s not a lot and I could pay it back pretty quick.