Life is unpredictable, subjecting us all to expensive complications at one time or another.
During those times, you might look at your 401(k) retirement savings and be tempted to make a temporary emergency withdrawal. But while borrowing from your 401(k) is an option, it may not always be a good one. Let’s talk about the downsides.
1. You’re missing out on investment growth
When you reduce the balance of your 401(k) account, you have less money growing along with potential gains in the market. In addition, some 401(k) plans have terms that prevent you from being able to make further contributions until the loan is repaid.
So not only are you missing out on potential gains on the amount you withdrew, you may also be slowing down the growth of your principal for the duration of your loan. If you’ve borrowed for the maximum term allowed — five years (longer if you use it to purchase a home) — all that inactivity can make a hefty dent in your retirement savings from which it can be difficult to recover.
2. It’s another monthly expense
It’s a loan, after all. You’ll need to make room in your budget to make the payments. And don’t forget that you’ll be paying back the tax-deferred amount you withdrew with after-tax money — another loan cost that’s often overlooked. To add insult to injury, you’ll pay taxes on it again when you withdraw it in retirement.
3. You’re risking a balloon payment situation that could lead to expensive consequences
It’s your employer’s plan. If you were to suddenly lose your job, the plan will most likely require you to pay the outstanding balance within 60 to 90 days.
If times get tough and you’re not able to repay the loan in time, it will be counted as a withdrawal from your retirement savings. You’ll have to pay income tax on the money, plus a ten percent penalty for early withdrawal if you are under age 59½ and the withdrawal did not qualify for an exception.
Of course, there may be times in your life in which it makes sense to borrow from your 401(k) — for example, if you’re truly in an emergency situation and can’t secure cash elsewhere. But, borrowing from your future should always be your last option and one you don’t exercise until you’ve considered all the risks.