Exploring the Two Biggest Traps Behind 401(k) Loans

By Stuart Robertson

Financial experts will usually tell you that tapping a 401(k) for a loan should always be a last resort. Most people already aren’t saving nearly enough, so taking a loan out makes the prospect of having a comfortable retirement even more challenging. Still, it can be tempting to pay off big credit card bills with interest rates of 20% or more—especially if they’re drowning you in a sea of debt. But before you reach for the 401(k) life preserver, it’s important to know how 401(k) loans work.

First, let’s dive into the aspects that can work to your advantage. 401(k) loans have great terms. You can take out a loan for up to 50% of your vested 401(k) balance (your contributions, rollovers, and any vested matching in your account), up to $50,000. The interest rate of the loan is generally low and is usually the prime rate plus 1%. You pay yourself back via payroll deductions directly to your 401(k) account, typically over a five-year period.

Another advantage? You get to avoid the risky credit checks you may experience when taking out other loans since you’re borrowing from yourself. The cost to take out the loan is generally $125 or less. While all of this may sound enticing, you also need to understand the risks that come with taking out a 401(k) loan. There are two factors that can make them especially hazardous.

Hazard #1: Taxes and Penalties

If you stop making payments on your 401(k) loan for 90 days, the outstanding amount of the loan is treated as a distribution. That means it loses its tax-deferred status and Uncle Sam will require that taxes must be paid on the outstanding amount, plus penalties. The IRS taxes the outstanding balance at your current tax rate. Plus, if you’re not of retirement age (59½), you’ll owe an additional 10% penalty. If you took out a loan, finding the money to cover this will likely be difficult—and only adds insult to injury. This scenario is less common as your payments are typically managed through payroll automatically.

However, much more common, and equally hazardous is if you decide to switch employers or lose your job. The unpaid balance must be paid often in less than 60 days. Any unpaid balance at that time is treated as a distribution and again taxes and the added 10% penalty applies if you are under 59 and ½ years of age. That’s not too kind to the pocketbook.

Hazard #2: A Dent in Your Retirement Savings

While borrowing from a 401(k) provides an easy and low-cost path to immediate cash, the impact on your retirement savings can be material. Time is the key to building a healthy nest egg. That’s why 22-year-olds who start by contributing small amounts to their 401(k) are often much better off than those in their 40s that contribute a much greater amount to their accounts. This effect is called compounding. When you take money out of your 401(k) through a loan, you lose out on the compounding this money would have experienced. This is why it’s important to explore your other options (bank loans, a home equity line, etc.) before turning to a 401(k) loan.

Planning Your Next Steps

Having access to a 401(k) loan does have some benefits like low rates and convenience when you’re in a pickle. However, the hazards that may come with taking out a 401(k) loan truly make it an emergency source of funds. Before resorting to this option, speak to your bank and credit card companies to see if they can give you better terms or access to loans that make your debt load more manageable. If you’re all out of options and do opt for a 401(k) loan, consider putting a plan together that enables you to pay the loan back more quickly than the schedule. This will help you minimize the hazards. Most importantly, by paying it back quickly, you’ll keep that money working for you over time, so you’re better situated for long-term savings you’ve worked so hard to accumulate.

This material is intended only as general information for your convenience and should not in any way be construed as investment or tax advice by ShareBuilder 401k. The owner/participant should consult with their tax advisor regarding any specific tax strategies.

Meet the Author

Our low-cost 401k plans are easy to setup online and are supported by our 401k advisors and specialists. ShareBuilder 401k serves small business and medium-sized companies, as well as the self-employed. We offer Roth 401k, Safe Harbor 401k, Traditional 401k, and Solo 401k options. Your 401k plan is paired with investment management expertise and employee education to help you save more.