One typically has a 401K account as savings for retirement. Taking out a 401k loan is generally not a good idea. Most people do not have enough money saved for retirement and need the 401K savings. Taking out a 401K loan will result in you earning less on the money left in the account. One usually counts on the earnings from interest to help fund their retirement years. One should generally try to find any other way of getting money than taking out a 401k loan. It is a risky move that often does not pay off.
The 401k loan is a financial option that many Americans need to know more about. While on the one hand they seem to present the opportunity for a low-stakes loan with yourself as the creditor as well as debtor, their primary downside of drawing down the available funds in your 401k is actually more significant than it seems. In this article, we will analyze 401k loans in detail to determine if they are a good choice and, if so, what circumstances make them a good idea.
Background: The 401k in Detail
The 401k plan is actually two different financial instruments, but they both have the same objective: to help workers save for their retirement. The basic format of a 401k is an account in which you, the worker, can deposit money, which gets deducted from your paycheck. Most workplaces offer 401ks, and they also generally go one step further — they provide you with a selection of options for investment. To save enough money to retire safely, you cannot simply leave your money alone. You need to invest and make a return to increase your wealth. The 401k is an excellent way to do that.
The main benefit of the 401k comes in the form of tax relief. Whenever you invest money, it gets taxed twice — first, you get hit with income tax when you receive the money as salary. After you get paid, you invest the money, let it sit for a while, and then withdraw it later. This withdrawal is also taxed. When you are investing for the long term, like when you save for retirement, taxes and fees start to become very important.
There are two forms of tax relief available in a 401k depending on which tax they protect you from. A basic 401k exempts you from the first tax — the income tax on money you invest in the account. Essentially, you get to invest money before taxes are taken out. That gives you more to invest and a larger principal to grow over time. A Roth IRA exempts you from taxes on withdrawals. So either way, you get some kind of tax relief.
The best one for you depends on whether you think your current income tax rate is higher or lower than what it will be at the time you retire. Of course, this is pretty hard to predict. What many people do is opt for a basic IRA and then go Roth for their IRA. In any case, having some kind of 401k and using it is much more important than what kind of 401k it is.
There is an additional bonus to having a 401k, although not everyone benefits from it: employer matching. Typically, most workers set up their 401k plans so that a percentage of their paycheck automatically goes to the 401k. This is a good idea, because it creates built-in good saving habits.
Employer matching is when your company tosses in some money as well based on how much you contribute. For example, if your company matches up to 3 percent and you automatically contribute 6 percent of your salary, then your 401k grows by 9 percent of your salary from each paycheck. It is free money. If your workplace has a matching program, try to max it out. If they do not, then investing using a 401k is still a very good idea — it just won’t entitle you to the same free money as a workplace that does matching.
Now that you know all of the important elements of a 401k, let’s talk about the 401k loan. A 401k loan is just what it sounds like: you borrow from the money in your 401k account. People usually do this to pay off debt or to make a big purchase.
Normally, if you try to withdraw money from your 401k before you retire, you face major tax penalties. That’s because the government wants to incentivize you to save that money for retirement. However, 401k loans are an exception, because they do not trigger big tax penalties. You simply borrow from the account and pay yourself back later.
The idea is rather appealing at first look — rather than borrowing from a bank, where you have to deal with high interest rates, late fees, and other problems, you are just borrowing from yourself. You can be relaxed about paying yourself back because you understand your own circumstances in a way that a bank never could. A quick infusion of cash can solve a lot of problems, like a big credit card bill.
However, if you think about it more, a 401k loan is actually a major risk. The biggest problem with a 401k loan is that you are taking away money from the 401k and therefore causing your assets to grow more slowly. The more money you have in a 401k, or any investment account, the faster it can grow. It’s simple math — if your account is growing at 5 percent a year, then you make more money if you have invested $20,000 than if you have $10,000.
Whenever you take out a 401k loan, you are reducing the amount of money in the account. As a result, you gain less from the growth of your portfolio. It might not seem like much, but keep in mind that when it comes to investing, little differences in the beginning add up to big differences at the end. One rough rule of thumb for young to middle-aged people is that one dollar invested now will be worth about seven dollars when you retire. So if you borrow from your 401k, you are depriving yourself of a lot of future wealth.
Now, of course, you plan to pay the loan off. First of all, that doesn’t matter. Your investment money is still lower than it would have been if you had kept the money in there in the first place. You would need to pay back the loan plus add extra money to replace the investment growth you never earned as a result of losing some of the principal. In addition, some people fail to pay back the loan. This is real and it happens. Not only does this mean you never catch back up to the original level, but you also face fines for this, because you essentially used the loan to make an unqualified withdrawal before your retirement.
The bottom line is that 401k loans actually put you in a position to lose much more than you might have expected if you didn’t think it through. The big sacrifice of losing out on investment growth is so important that you should only borrow from your 401k if it is a true emergency and you have no other financial resources that you can use to solve the problem.
The money in a 401k is meant to be left alone until you retire, and that’s especially true for people without other savings mechanisms. Don’t risk compromising your retirement for money today — that’s exactly what the 401k is meant to avoid.