5 Reasons NOT To Borrow Against your Retirement Plan

It’s not uncommon to hear around the water cooler that it’s a good idea to borrow against your 401(k) because you “pay yourself back  - with interest”.  While it is true that you pay yourself back with interest, that doesn’t necessarily mean it’s a good idea. 

Here are 5 reasons why you might want to rethink that approach:

Opportunity cost

When you borrow money from your 401(k), it’s no longer invested.  That means you’re giving up the future growth potential on the money you withdraw from the plan.  Note that this is a difficult concept to quantify.  It’s easy to compare interest rates and the financing costs of the loan, but you can never truly account for the lost compounding effect.  This is due to the fact that it is virtually impossible to accurately predict the future returns.

Did you know?

“The interest rate paid on a retirement plan loan is often less than the return that the retirement funds would have otherwise earned”. ~ U.S. General Accounting Office

Potentially Smaller contributions.

Because you now have a loan payment, you may be tempted to reduce the amount you are contributing to the plan and thus reduce your long-term retirement account balance.

Double Taxation. 

This can be a tough one to grasp, stick with me here…

The money you invest in a 401(k) plan is often with pre-tax dollars. Money used to repay the loan is always after-tax dollars.  Fast-forward to retirement…when you make withdrawals in retirement those withdrawals will be taxed – including the loan repayment dollars (that were taxed when you repaid the loan).

This means the additional interest going into the account will effectively be taxed twice – when you contribute and again when you withdraw the cash from your account in retirement. 

Loan default.

If you quit working or change employers, the loan generally must be repaid within 60 days. If you are unable to repay the loan, it’s considered a distribution from the plan and will be subject to applicable taxes and a 10% early withdrawal penalty if you are not at least age 59 ½.

Fees. 

While this is true of all loans, there are typically administrative and maintenance fees associated with a retirement plan loan.  

As is the case with everything in personal finance, there is no absolute rule about borrowing against your retirement plan, it really comes down to finding the right approach for your unique circumstances.

Try this brief quiz to see if a retirement plan loan might make sense for you:

1. If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home-equity loan, etc.)?

2. Would the after-tax interest rate on the alternative (non-401(k)) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?

3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?

4. Are you comfortable with the requirement to repay any outstanding loan balance within 60 days of separating from your employer, or pay income tax and a 10 percent penalty on the outstanding loan?

If you can answer “yes” to all four questions, the 401(k) loan might be advantageous for you; otherwise, other options likely make more sense.

You can also try this calculator to see if a retirement plan loan might make sense for you:

http://www.bankrate.com/calculators/retirement/borrow-from-401k-calculator.aspx