You may have heard great stories from friends and co-workers who have borrowed money from their 401(k) to pay for things like weddings, cars and vacations. You are not alone. According to the Employee Benefits Research Institute, about one in six people who are eligible to take out a loan from their 401(k) plan has done just that. Before deciding to do the same, take a minute to think through the pros and cons. As you drive along that scenic highway toward a happy retirement, one of the surest ways to undermine the trip is to end up having (metaphorical) car trouble.
As with other ways you might be tempted to borrow against the future, like high-interest credit card debt, a 401(k) loan is quick and easy. Most employers make it very easy to take out a loan against a 401(k), with little or no paperwork and a quick turnaround. When you pay it back, your principal and interest payments will be automatically deducted from your paycheck and put into your 401(k) account. It is practically like pulling into a rest stop along the highway.
In addition to being easy to do, a 401(k) loan is also relatively easy to understand. The terms are straightforward, so you won’t have that feeling of being intimidated or “getting in over your head.” You can usually borrow up to $50,000 or one-half of your contributions and vested employer contributions, whichever is less. You then have a relatively short repayment period, five years being a typical example.
Of course, this also brings up the fact that you will be caught up again so soon. This is even more tempting if you are younger, because when you look 30 or 40 years down the road to retirement, taking a little time off now doesn’t seem so bad. I mean, this is a big road trip, right? What’s one extra rest stop along the way?
The last thing to mention in the “pros” category is that you will probably be offered a very appealing interest rate. Rates are quite competitive, usually prime rate plus 1 percent.
Of course, all of these are appealing features, but don’t run out and sign any paperwork yet. This is one of those places where life doesn’t always match up to the road map, and you need to make sure you allow for detours, construction, etc.
By focusing on the fact that five years in the context of 30 or 40 seems no worse than a short time out, you are making an important mistake in relation to the compounding value of money. Not all years are created equal. What that means is that losing out on five years at the beginning of your financial road trip costs a lot more than losing out on five years later on. Compounding returns are like the octane in your gas, helping to fuel the growth of your retirement fund, and you lose compounding when you take your money out for the loan. In addition to losing out on the compounding from the loan amount itself, if you stop making contributions while you’re paying back the loan, you’ll lose out even more. Do you really want to be, figuratively, in the middle of nowhere when you realize that the really cheap gas you put in the car at the last rest stop is causing engine trouble?
Because the average person does not tend to think in relation to taxes whenever they are faced with the lure of a new car or a vacation, it is easy to overlook the fact that you will end up paying more taxes. You make your loan payments with after-tax money, but when you take distributions from your 401(k) upon retirement, you’ll still owe taxes on all that money. This means that you’ll end up paying taxes twice on the money used to pay back your loan.
And then, of course, there is always the possibility of detours, construction delays, and rock slides that could get in your way. In this case, if you leave your job, the loan term comes due. That means if you quit or are fired, you’ll have to pay the loan back in full immediately, which is usually not a great situation when you’ve just left a job.
On the road to a healthy, happy retirement, borrowing from your 401(k) should be a strategy of last resort. Like one of those small emergency tires that come with a lot of cars, this financial gadget will work, but not great, so only use it if you really don’t have an alternative.