Curious About 401(k) Loans? Read This:
“What happens when I take a loan from my retirement account?”
Whether it is to meet an urgent need or a long-expected large expense, many people turn to their retirement account for a loan. And it is easy to see why: there is no credit check, the interest rate is low and the application process is easy. And in fact, when you pay back the interest, you pay it into your own account. But is this all too good to be true?
First, a primer:
You can only take a loan from a workplace retirement account such as a 401(k), 403(b) or similar (Roth or traditional). You cannot take a loan from an Individual Retirement Account (IRA) of either type.
When you take a loan from your retirement account, you reduce the amount of money you are saving for retirement. Yes, over time, you will replace this amount by paying back the loan, but any amount of time that these loan proceeds are not invested will reduce your eventual retirement nest egg.
Now, the details:
Much more worryingly, depending on your employer you may be prohibited from making new contributions to your retirement account during the period of time that your loan is outstanding. This could cause great damage to the health of your retirement plans, and particularly so if this causes you to lose a matching contribution from your employer. If you forgo investing $5000 a year for 5 years, your nest egg could be diminished by more than $90,000, 20 years later. If you are able to handle both continued contributions to your retirement plan while paying back your loan, you can mitigate this problem by making contributions to an outside IRA account during the time that your loan is outstanding.
In most instances, your employer will take the loan payment directly from your paycheck (after tax) which limits the risk of default. Consider carefully if your monthly cash flow needs can withstand this lower paycheck.
But what happens if you leave your employer? In that case, the entire loan balance is likely to be due in full immediately. If you do not pay it back, the outstanding amount will likely be considered an “early distribution” if you are less than 55 years old. As such, it is subject to a 10% penalty (which you will pay when you file your next tax return) and included as taxable income.
Finally, tax nerds will notice that you may be double-taxed when you take a 401(k) loan. You pay back the loan with after-tax money and then when you retire, your withdrawals from a traditional retirement account will be taxable.
Life is complicated. In a perfect world no one would ever tap their retirement savings early. Taking a loan from your retirement account to meet a true emergency is sometimes the least bad choice in the moment. But is there another way you can meet this need without endangering your future wellbeing? (Is it truly an emergency?)
If you do decide that taking a loan from your 401(k) retirement account is the path that you must take, the key is to limit the future ill effects on your retirement security: pay the loan back as soon as possible and if you are able to continue investing during the period of time when the loan is outstanding, it is critical to continue doing so even if you must do so outside of your workplace retirement plan.