Top 5 Reasons Not to Borrow Against Your 401k

posted by Melissa Cappleman
May 20, 2009

Are you thinking about borrowing against your 401k? With the value of your 401k going down, wouldn’t it be better to use it before you lose all of it?

Unless you are facing foreclosure or bankruptcy, you should NOT borrow against your 401k and here’s why:

  1. The loan is tied to your employment. At some point, you WILL be leaving your employer. It may or it may not be your choice to leave. Regardless of how or when you leave, the loan will need to be repaid.
  2. If you don’t repay your loan within 60 days of leaving your current employer, the IRS will view the remaining amount due as a distribution (withdrawal). Unless you are at least 59 ½ years of age, you will be taxed at your current tax rate PLUS 10% for an early withdrawal penalty.
  3. You pay double taxes. When you make contributions to a standard 401k, the contributions are in pre-tax dollars. When you’re repaying a loan, you are using after-tax dollars. When you retire, you will have to pay taxes on the distributions again. Additionally, the interest paid on the loan is not tax deductible, even if you use the money to purchase your primary residence.
  4. The borrowed money is not growing. You unplug your investments while you are repaying the loan. This means that you are not paid while your investments increase in value. Stocks are on sale right now. The only way they’ll go from here is up. Even though you’re paying yourself interest while repaying the loan, the interest rate paid is often less than the rate your investments would have otherwise earned.
  5. It is only a bandaid solution. You are essentially trying to solve the problem of having too much debt by once again borrowing the money. While this strategy might work in the short term, you will find yourself back at square one just a few months down the road.

Figuring out how to repay large debt is always difficult. In a bad economy it might seem impossible.   That is why it is especially important to recognize the need for professional advice.  Many financial coaches and advisors will have an initial consultation free of charge.  Once you start working with them, together you will come up with solutions that will work for your particular situation.

If you are facing foreclosure and/or bankruptcy, go ahead and borrow against your 401k. But borrow only the amount you actually need. Otherwise, you’re better off finding other ways to repay your debt.

 

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