You know the expression about something being too good to be true? That’s the case when it comes to borrowing from your 401(k). This might seem like a good idea when it comes to making a large purchase or paying off debt, but there are consequences. You are not just borrowing from yourself. Because of the effects of compound interest, you’re actually borrowing from your future self, and robbing yourself of the blissful retirement you deserve. And why would you want to do that?
If you are thinking of borrowing from your 401(k), here are some important things to consider first.
You’re Missing Out on Money
Interest rates on 401(k) loans can be very appealing. You have the ability to borrow your own money and pay interest to yourself rather than a bank. Seems like a good deal, right? But not only are you missing out on the effects of compound interest, but the market may end up making money.
What this means is when you take out a loan you’re actually selling your assets. Then, when you go to repay your loan, you may end up buying shares in a fund at a higher price.
It is also important to note that if you’re unable to repay your loan within the time frame allowed, your loan will be considered an early withdrawal. This mean you will pay a 10% penalty if you are under the age of 59 ½ and have to pay extra income tax.
You Get Taxed Twice
For a traditional 401(k) plan, you make contributions with pre-taxed dollars. You won’t actually pay any taxes until you withdraw from your account as income during retirement. However, by borrowing from your fund, you will effectively be taxed twice. This is because you’d be paying back the loan with after-tax dollars. Then, when you wish to withdraw during retirement, you will be taxed again.
You Can’t Make Contributions Until the Loan is Repaid
Typically, most 401(k) plans will not let you continue to contribute money until you have repaid the full amount you have borrowed. Since this could take years, this means missing out on years of potential contributions (and the effects of compounding interest). You will miss out on the growth and interest you would have accumulated had you just left your money where it was.
It Could Be Risky
If for some reason you stop working or are let go by your employer, you may be required to repay the loan in full within 60 days. If you cannot meet the payment obligation, your loan will be considered an early withdrawal and you’ll have to pay the 10% penalty as well as income taxes! Talk about a big blow to your bank account!
You’re Stealing from Yourself to Pay Someone Else
By using your 401(k) to pay off debt, you are essentially just moving your debt around, as you will still have a loan that needs repaying. Some see this as a better option than paying a bank because interest rates are lower. However, even if you pay your loan back on time, you will have lost out on maximizing the effects of compounding interest. You are really just robbing from your future self.
Now you can see why taking a loan on your 401(k) may not actually be a great idea. While it may seem like an easy way to access immediate funds, you’re only hurting yourself. Instead, make a plan to save for a big purchase or develop a debt repayment plan that doesn’t involve needing to dip into your 401(k). With proper planning and a little patience, there are usually ways to reach your goals without compromising your future.
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