Contemplating a 401(k) Loan? Understand the Pros and Cons

If you’re considering taking a loan from your company 401(k) plan, it’s important to first understand the pros and cons. While borrowing from yourself may appear to have its advantages - including low-interest rates and repayment plans that are easily managed from paycheck to paycheck - such decisions should not be taken lightly. In this video, we will explore the financial implications of tapping into your own retirement fund when times are tough so that savers can make an informed decision about whether or not they should consider this option.

Video Transcript:

If you take a loan from your 401k plan, you'll borrow from your own retirement account and pay yourself back with interest. Sounds good, right? Not always. Borrowing from your 401k can be harmful to your short and long-term savings goals.

Here's why: First, when you take a 401k loan, you are borrowing money that hasn't been taxed yet, but you pay the loan back with after-tax dollars that get deducted from your paycheck.

Eventually, when you withdraw that money, it will be taxed again. That means you're being taxed twice on your retirement savings.

Second, you will likely stop contributing to your 401k plan. Why? Because the loan repayments will reduce your take-home pay, giving you less cash to work with each month.

Third, when you stop contributing pre-tax dollars to your 401k, your taxable income will increase, which could put you in a higher tax bracket.

That means you guessed it, higher taxes. So taking a loan not only halts your retirement savings momentum, but it could give you a higher tax bill.

Fourth, did you know if you leave your job and haven't paid back your loan, you may owe taxes and penalties. Your former employer could require you to repay the outstanding balance. If you can't pay it off, the balance could be reported to the IRS as a distribution and distributions are taxable. There's more bad news, if you're younger than 59 and a half, you'll have to pay an extra 10% penalty to the IRS.

Fifth, and finally, the money you removed from your 401k will no longer be invested. And when you're not invested, you are not earning interest and benefiting from potential market gains which could translate into less money when you retire.

So think twice before borrowing from your 401k so you can preserve your hard-earned retirement savings.