That 401(k) Loan Is a Terrible Idea—Here’s Why

Credit & Debt, Retirement & Investing
on September 17, 2014
Why a 401k Loan May Be a Terrible Idea
Thinkstock
http://smartycents.com/wp-content/uploads/2014/09/nope-150x150.jpg

Saving for retirement is one of the best things you can do for your financial future. Check that, it IS the best thing you can do for your financial future. If you aren’t saving for retirement, or you aren’t saving enough for retirement, then you just aren’t going to have the financial future you want. But simply “saving for retirement” doesn’t mean you are on easy street. There is one way you can ruin your chances of retirement even if you are saving for retirement, and it’s by taking a 401(k) loan. If you’re already angry, you aren’t alone, but allow the evidence to convince you.

Consider this scenario: You’re chugging along saving 8% of your income for retirement, plus a 3% match from your employer. By all accounts, you’re doing well. But then the roof needs replacing, or your kid needs to go to college, or you want to pay off some debt. Then comes a whisper in your ear, “What about a 401(k) loan?” Your co-worker has been talking up how much it helped him redo his kitchen. He even said it makes more sense than another type of loan because you are paying interest to yourself. Sounds pretty good! So you fill out the paperwork and cash out a chunk of your 401(k).

What’s wrong with this scenario? You never once considered the implications for your future. You were so focused on your present needs that you forgot to take into consideration your future needs, the ones presumably to be covered by that 401(k) you just dipped into. This is a colossal mistake. Think of it this way. You can finance a car, a house or a college education, but you absolutely cannot finance a retirement.

Cue defensive statements:
“I swear I’ll pay it all back!”
“I’m paying interest to myself; it just makes sense.”
“It’s my money. I can do what I want with it.”

A 401(k) is an easy-to-justify loan. You are indeed borrowing from yourself, and when you pay yourself back, the interest goes to you. But there are two important elements this argument doesn’t take into account. First, you’ll be losing out on compound interest, and second, it’s likely you will now be making loan payments instead of contributions to your savings. Keep an open mind as we dig deeper into these reasons.

If your original retirement account had $50,000 in it, and you take out a loan for $25,000, then your retirement account drops to $25,000. You are no longer going to gain interest on $50,000—now you are only gaining interest on the $25,000. If you took out the loan on January 1, 2013, you essentially shielded $50,000 from a 30% growth year (S&P 500 return 2013). This is a loss of great magnitude. And yes, you did pay yourself some interest, but it is nowhere near comparable.

You swear you will pay back the loan, and I’m inclined to believe you, but what you aren’t considering is the contributions you made prior to taking on this loan payment. Each company’s policies on 401(k) loans will be different, but some companies won’t let you contribute to your 401(k) while you are paying off your loan. This means that for the five years you are paying off your loan, you are missing out on the 8% you were contributing previously, PLUS the 3% match your employer provides. You are already losing money left and right.

Some companies will let you continue to contribute to your 401(k) while repaying the loan, but will you be able to? If you couldn’t afford to fix your roof/pay for college/get out of debt on your own, are you really going to be able to afford the loan payment and the 8% contribution you were making previously? It’s highly unlikely.

If you still aren’t convinced, let’s discuss what happens if you are let go or decide to move to a new company. Your 401(k) loan may have a repayment period of five years, but if you leave your company, it will be due immediately. Yep. Immediately. Oh, and to add insult to injury, if you can’t pay it back, you will have to pay taxes on the withdrawal amount, because it will be classified as a non-qualified withdrawal. PLUS you will owe another 10% if you are under the age of 59 ½. The hits keep coming.

You should be sufficiently scared at this point. And that’s a good thing, because a 401(k) loan is no joke. The best-case scenario is that a 401(k) loan sets back your retirement a few years. The worst-case scenario is that you won’t be able to retire at all. These 401(k) loans are often treated as a last resort option, but you need to remove the idea from your list of possible backup plans altogether.

Peter Dunn, aka Pete the Planner, is an award-winning financial mind who has authored five books, hosts the popular Pete the Planner radio show and travels around the country offering financial education. His signature wit will have you laughing as you learn. For more from Peter, visit www.petetheplanner.com.

Related Article: Solving the Retirement Cash Flow Puzzle

%d bloggers like this: