The Pros and Cons of Borrowing from Your 401(k)
Are you considering a 401(k) loan? Your 401(k) account is intended to fund your retirement, but you might have the option to withdraw money from it earlier for a few unexpected life events, like medical expenses. That said, beware of the negative consequences that could arise with this decision.
It goes against our personal finance philosophy to take money out of a retirement account before retirement, but under the right circumstances, it could be an option to consider. Here are some pros and cons of a 401(k) loan:
Pros of Borrowing from Your 401(k)
- No credit check. – If your credit score is not ideal, you might have a hard time getting a loan. As long as your 401(k) allows for loans, you should be able to borrow without a credit check to a bank.
- Convenience. – Borrowing from your 401(k) usually requires less paperwork and is a quicker process than standard or personal loans.
- Borrowing at a competitive interest rate – and then repaying yourself. – The rate you pay is dependent on the terms of your 401(k) plan, which is typically lower than the rate you will pay on a personal loan or credit card. Plus, the interest you pay will be to yourself instead of a finance company or bank.
Cons of Borrowing from Your 401(k)
- Opportunity cost of not being fully invested. – When the market rises, the money you borrowed might miss out on potentially higher returns. Many people who borrow from themselves also stop contributing. Think how much you could lose if you stop contributing to your principal.
- Risk of job loss. – A 401(k) loan can be treated as a distribution. This loan is subject to taxes and a 10% penalty if you are under the age of 59 ½. If you were to switch jobs or get laid off, the balance you borrowed becomes immediately due. If you repay it back within 60 days, you will face tax consequences.
- Warning about your financial health. – Borrowing from your retirement account(s) to fund your large expenses could be a red flag or sign of overspending. While you might be saving money by paying off your high-interest credit-card balances, you might end up doing more harm than good to yourself. If you do not address your underlying spending problems, you risk reloading the credit cards with high balances and paying high-interest rates again.
Closing Thoughts
We seldom advise our clients to borrow from their 401(k) plan. Yet, we also understand that under the right circumstances, it might be an appropriate option.
I encourage you to seek out professional help before making this decision on your own. We want you to make the best decisions for your situation and future. You can schedule a second opinion with us to make sure you are avoiding large penalties, have a solid understanding of any potential taxes, and that you are making the best financial decisions possible.