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:
Should you borrow from your 401(k)? Generally, not if you can help it. Have you exhausted all of your options? Is a 401(k) loan even allowed under your plan?
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.
How do you plan to use the proceeds? Some retirement plans are stringent and only allow you to borrow under very specific conditions such as college expenses or a first time home purchase. Other plans are more flexible. Regardless of whether the plan administrator asks you the hard questions, you should still ask. Life happens to everyone, and there are situations where the loans make sense.
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.
Are you happily married to your employer? I know this sounds like a weird question, but it is a legitimate one. Before pulling the trigger and applying for a loan, make sure that you are committed to that company (and they are reasonably committed to you) for at least another five years. As long as you make your agreed upon payments you’ll remain in good standing with the plan. Once you are no longer employed with the company, however, the dynamics can change quickly. Many retirement plans require that borrowers repay all outstanding loans within 60 days of separating from that employer.
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.