When money is tight, many people seek relief through a 401(k) loan. While this may seem like a good idea, consider these questions before making a final decision:
When it comes to 401(k) loans, this really should be one of your options of last resort. The last thing that you want to do is get in the habit of viewing your retirement account as your rainy day fund. If you compromise your retirement money to pay off your bills today, then what is going to be left to pay your bills in retirement?
I have heard all of the merits of why it is better to pay yourself interest instead of a bank. The cost of borrowing is the interest that you pay for the loan. The cost of the loan to your retirement is much more expensive, however, because borrowers often reduce their retirement contributions in order to pay back the loan. Five years of reduced contributions, employer matching contributions, and any corresponding earnings, can take a noticeable toll on your retirement.
However, if the loan is for something like a vacation of a lifetime, then think about it some more until you talk yourself out of it.
What few people realize is if they can afford to pay back a loan to their 401(k), then they can afford to pay for the expense themselves by setting aside money in a savings account. Doing so is easier than you may think, especially if your employer allows you to deposit your paycheck into multiple accounts. Commit to saving for the things you want to do without it being at the expense of your retirement.
If having it removed from your paycheck before you see it makes it easier for you to commit, then set it up. Many employers allow you to have your paycheck direct deposited into multiple accounts. You don’t need a loan to force you to make payments. If you make paying yourself a priority and a habit, then you can avoid raiding your retirement reserves for anything other than retirement.
At that time, the plan treats the unpaid balance as a distribution. In that scenario, the money that you borrowed under favorable terms loses its appeal when you receive the 1099 for the defaulted loan balance and the tax bill that is sure to follow.
Making the decision to borrow from your 401(k) should not be taken lightly. After all, there is a fine line between borrowing from yourself and robbing yourself of your retirement.
Life is a journey. Plan for it.