8 Reasons to Avoid 401(k) Loans

Most 401(k)s allow you to borrow up to 50% of the funds vested in the account or $50,000, whichever is less, for up to five years. Because the funds are not withdrawn, only borrowed, the loan is tax-free. You then repay the loan gradually through payroll deductions, including both the principal and interest. But dipping into the savings in your 401(k) plan is a bad idea, according to most financial advisors. But that doesn’t deter nearly one in three account owners from raiding their funds early for one reason or another.

Here are eight reasons advisors believe 401(k) loans are a bad idea.

1. Repayment Will Cost You More Than Your Original Contributions

The leading advantage of a 401(k) loan—that you’re borrowing from yourself for a pittance—looks dubious once you realize how you’ll have to repay the money.

The funds you’re borrowing were contributed to the 401(k) on a pre-tax basis (if it’s a traditional 401(k) account rather than a Roth account). But you’ll have to repay the loan with after-tax money, which means you’ll be taxed again on that money when you begin taking distributions.

Say you’re paying an effective tax rate of 17%. Every $1 you earn to repay your loan leaves you with only $0.83 for that purpose. The rest goes to income tax. Put another way, making your fund whole again would require roughly one-sixth more work than the original contribution.

2. The Low Interest Rate Overlooks Opportunity Costs

When you borrow money from your account, it won’t be earning any returns until it’s repaid. Those missed earnings need to be balanced against the supposed break you’re getting for lending yourself money at a low interest rate.

“It is common to assume that a 401(k) loan is effectively cost-free since the interest is paid back into the participant’s own 401(k) account,” says James B. Twining, CFP, CEO and founder of Financial Plan Inc., in Bellingham, Wash. However, Twining points out that “there is an ‘opportunity’ cost, equal to the lost growth on the borrowed funds. If a 401(k) account has a total return of 8% for a year in which funds have been borrowed, the cost on that loan is effectively 8%. [That’s] an expensive loan.”

3. You May Contribute Less to the Fund While You Have the Loan

Some plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn’t stipulate this, you may be unable to afford to make contributions while you’re repaying the loan.

Such a freeze will deprive the account of money that should, in the long run, multiply many times in value through compound earnings. Most calculations suggest that your money will double, on average, every seven years while invested. The gap will be wider still if your skipped contributions lead to missed matches by your employer.

4. If Your Financial Situation Deteriorates, You Could Lose Even More Money

The drawbacks above assume you’ll be able to make the scheduled payments to your fund on time and without undue hardship. In fact, the vast majority—88.9%—are able to do just that, according to Bank of America’s Participant Pulse survey of retirement accounts.

However, should you be unable to repay the loan, the financial implications go from bad to worse. If you default on a 401(k) loan, the loan is converted to a withdrawal. Unless you qualify for a hardship withdrawal, the outstanding loan balance will be subject, at minimum, to taxation at your current income tax rate. If you’re under the age of 59½, you’ll also be assessed a 10% early withdrawal penalty on the amount you’ve borrowed.

5. A Job Loss or Departure Accelerates the Repayment Clock

Many plans require you to pay off any loans in full if you quit or lose your job. If you can’t pay it off within the period specified by the plan, your remaining balance may be used to pay off the loan. Also, the loan will be considered a distribution, and you’ll be hit with income taxes and a 10% early distribution penalty if you’re not 59½.

You may be able to roll the offset amount (the amount you’ve borrowed) into an eligible plan to avoid taxes, but this ability depends on whether the new plan allows it and whether you’ve taken all other appropriate actions.

In any case, the presence of a loan you’d have trouble repaying early could handcuff you to your current job or force you to pass up a better opportunity.

6. You’ll Lose a Financial Cushion

Your 401(k) balance may one day represent the last possible weapon to stave off financial disaster. If you exercise the nuclear option and press the button, that money won’t be there if a true emergency strikes.

7. A Loan May Encourage Poor Financial Practices

Borrowing from your future should encourage you to examine how you got to this point in your finances. The need to borrow from savings can be a red flag, a warning that you are living beyond your means and need to consider changes to your lifestyle.

When you can’t find an alternate way to fund your lifestyle (other than by taking money from your future), it’s time to re-evaluate your spending habits. That includes creating, or adjusting, your budget and making an orderly plan to clear any accumulated debts.

8. You’re Unlikely to Repay the Loan Quickly

Advisers warn against having high confidence that you’ll repay a loan from your 401(k) in a timely way—that is, in fewer than the five years you’re usually allowed to take out the funds. “People think that they will make up a withdrawal later, but it pretty much never happens,” says Chris Chen, CFP, wealth strategist, Insight Financial Strategists LLC, Newton, Mass.

The Bottom Line

Taking a loan from your 401(k) is not a good idea, short of a dire emergency. But that doesn’t stop some account holders. According to data from the Transamerica Center for Retirement Studies, 33% of plan holders withdraw money outright from their account, often using hardship provisions.

Still, borrowing from your 401(k), most financial advisors say, goes against almost every time-tested principle of long-term investing.