If you are facing a large amount of debt or a big unexpected expense and have a sizeable amount of money built up in your retirement account at work, you might be tempted to borrow from your 401(k). But is that the right thing to do?
Why borrowing from your 401(k) should be your last resort
It’s a question money expert Clark Howard gets all of the time, and he feels very strongly about the answer:
“Almost 100% of the time people have asked me about borrowing from their 401(k), the answer is ‘No!'” Clark says. “That has to be the last option and something you do when you’re out of all other possibilities.”
“When people do borrow from a 401(k), historically it means that they end up with not near enough money to live on in retirement,” he says.
That’s scary, considering that according to a study from the Investment Company Institute, nearly one in five people who are eligible have a loan against their 401(k). Here are the main reasons it’s not a good idea:
You’re likely to reduce or stop your contributions during payback
Research from Fidelity says about a quarter of people who take a 401(k) loan reduce how much cash they put away for retirement while they’re repaying the loan. That’s because they’re struggling to make those payments back. Worse still, 15% of people end up stopping contributions completely within five years of taking a loan.
“Even a single loan from a 401(k) can throw you off-track because you lose so much time in saving for retirement and having to pay back that loan, which often reduces what you can contribute,” Clark says.
The ‘I’m paying myself back’ rationale isn’t so straightforward
When people do a 401(k) loan, they tend to justify it by saying, “Well, it’s my money — I’m paying myself back.” But the thing is, you are paying yourself back with after-tax money that will be taxed again when you retire.
You’d better keep your job
Clark: “Also remember that if you leave a job — whether they fire you or you leave on your own — the money on that loan is due pretty quickly. If you can’t pay it, you trigger a HUGE tax bill, plus penalties.”
In the past, you generally had just 60 days to pay back the loan before the taxes and penalties would kick in. Under the new tax law, you have until the due date for filing the taxes for the year in which you leave your job.
For example, if you leave your job sometime in 2019, you have until April 15, 2020 (October 15 if you file an extension) to pay back the loan in its entirety. Still, not necessarily a long time.
The real cost is opportunity cost
In the long run, the stock market has a lot more up years than down years. If you’re not as invested in the market because you’ve reduced or stopped your contributions during payback, you’re missing a lot of the gain that takes place over time.
“I’ve told you in the past about the heavy taxes you have to pay on your money when you tap into it before retirement,” Clark says. “But the big cost here is an opportunity one. If the money’s not there, it has no chance to grow and multiply over the years.”
The net effect is less for you in retirement
A 401(k) loan today can mean a big reduction in what you have to live on in retirement. You might either have to work more years to make up for it or be in near-poverty during retirement.
“Even though the interest rate on that 401(k) loan seems really good, the problem is that you are devastating your future. You are taking money out of that account that you will never recover,” Clark says.
Although it may look attractive, a loan from your 401(k) is almost never a good idea.
“Most people want to be able to retire at some point and have leisure time,” Clark says. “Borrowing against your retirement plan is a sure way to sabotage your future.”
- You should avoid borrowing against your 401(k) unless there are no other options
- Borrowing against your retirement plan can put you in a really tough spot in the future
- If you do have to borrow against your plan, do whatever it takes to keep saving for retirement