In the recent past, when people needed cash for emergencies, they typically tapped the equity in their homes via a home equity loan or home equity line of credit. Since the Great Recession, retirement accounts have replaced the home-equity loan as the predominant source of cash. They have become America’s new piggy bank. However, there are many reasons to avoid borrowing against your 401(k) account.
You lose the power of compounding – Pulling money from your 401(k) means that you are selling some of your investments. If they continue to rise in value, you will not get the profits and the compounding power that goes with reinvesting them. In addition, you are likely to sell low and buy high. As you pay back the “oan,” you are rebuying the previously sold shares—but at current (and probably higher) prices.
You will be charged added interest and fees – Most plans charge an origination fee of $75 regardless of loan size, and this goes to the administrator—not back into your account. Thus, if you borrow $1,000, you have lost 7.5% right away. While the interest you pay, which is based on prevailing rates, goes back into your account, that is money you otherwise could have invested for potentially higher returns. So paying interest—even to yourself—reduces the amount of wealth you could otherwise generate.
Contributions could be suspended – Many plans will not allow you to contribute to your 401(k) until you have paid off your loans. In some cases that could mean years, during which period you have lost the advantage of reducing your taxable income.
Your take-home pay will be reduced – Most plans require you to start repaying your loan via automatic paycheck deduction starting with your next pay. Thus, your take-home pay is reduced, possibly by more than the amount you were contributing to the plan before. And this repayment is not tax-deferred, so your taxes could rise, lowering your net pay even further.
Failure to repay by the deadline will trigger a tax risk – Most 401(k) plan loans must be repaid within five years. If you fail in that, your employer will treat the loan balance as a distribution, triggering income taxes and the 10% early withdrawal penalty if you are under age 59½. You could also be forced out of your plan and prevented from contributing in the future. Also, you will incur double taxation. Loans from your 401(k) actually cause you to pay taxes twice. Why? Because you are repaying with after-tax money and then later, when you withdraw the funds in retirement, you will pay taxes on that same money again.