Before taking a loan from your 401k, consider this…
Why did you contribute to your 401k in the first place?
To save for retirement
This is an admirable goal – one that your future self will thank you for. Many 401k plans do not allow you to make contributions while you have an outstanding loan. This means that you may also be missing out on employer matching contributions – which means you could be turning down free money!
For the tax-deferred growth
When you take a loan from your 401k you aren’t taking a loan using your 401k as collateral. You are literally taking the funds out of your 401k and paying them back over time. Meaning that you would lose the potential tax-deferred growth on those funds while the loan is outstanding.
For the tax deduction or tax management
If you contributed to your 401k on a pre-tax basis, common with a traditional 401k, then you did not pay taxes on those funds when you contributed them. When you withdraw the funds in retirement, you will pay taxes on the original contribution and any growth that has occurred in the account, but you don’t pay taxes annually on the growth (hopefully) occurring in the account.
When you take a loan from your 401k, you take out the pre-tax funds you contributed, and then you pay those funds back with after-tax funds. And then, in retirement, you pay taxes on all of the funds you withdraw, including those repaid loan dollars.
What happens if you separate from your employer?
Another major consideration should be what happens if you separate from your employer with a loan outstanding against your 401k. The 401k plan document itself sets forth the options for repaying the loan at that point. In some cases, you’ll be able to continue paying off the loan in regular installments. However, in other cases, the loan may be considered a distribution immediately.
There is also the difference between the plan’s treatment of the loan vs. the tax treatment to consider. If your plan forces the distribution treatment of the outstanding loan balance at termination, the IRS allows you to “pay it back” into a rollover IRA prior to the due date of your tax return without penalty. However, this still means that you need to have the cash to put into the rollover IRA.
Another thing to consider is that even if you are able to continue payments on an outstanding loan when you separate from your employer, that option is only available as long as you keep the 401k with the current plan. If you choose to rollover the 401k to an IRA or to another plan, the outstanding loan amount will be considered a distribution.
Yes, there are times when a 401k loan makes sense or may be the only option. However, I suggest that the 401k loan be considered in emergencies or as a last resort.
It is true that you’re paying yourself interest. But you’re paying interest with after-tax dollars whereas, if you left those dollars in the 401k, they could be earning tax-deferred returns on your investment. And, while the interest rate on a 401k loan may be low, that means you could likely have made a better return on those funds by keeping them invested.
Also, keep in mind the employer does not have to approve a 401k loan. So, you should not simply assume that the option is always available to you. They don’t do a credit check, but they may use other factors in their decision, such as the reason for the loan, or your history of taking loans from the 401k. If you’re near retirement or the end of a contract, they may also question the ability to pay back the loan. Since regular deductions from your paycheck won’t happen after separation from the company.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.