Why a 401k Loan Might Not Be the Best Option

Unless the organization you work for is providing you with a pension, your 401k will be a critical tool for maintaining your lifestyle throughout retirement. Given the prospect of inflation in a post-retirement economy, more workers should be focused on growing their 401k, instead of borrowing money from it.

Instead, more than ever, workers are borrowing money from themselves in the form of 401k loans. There are many reasons someone may choose to take out a 401k loan, but the results are almost always the same, the loan ends up costing the worker and potentially jeopardizing the retirement safety net provided by a 401k in the end.

If you are considering borrowing money from your 401k, there are a few things you should keep in mind. Even though you are technically borrowing money from yourself, the effects of a 401k loan may be more damaging than most workers realize.

Why Your 401k Is Important

The rising cost of living expenses and medical care is a driving reason behind the importance of a 401k. If you will not be earning income during retirement, your 401k will provide the funds needed to maintain your lifestyle.

One of the main benefits of utilizing an employer offered 401k plan is the fact that investments are made pre-tax. This means your investment into your 401k is made before your income is taxed. This essentially reduces your taxable income, making you technically bring home more than you would otherwise if 100% of your income was taxed.

By making regular contributions to your 401k, you can grow your retirement account at a faster pace than you could with most other retirement investing plans. Compounded by the fact that many employers will match your contribution into your 401k, up to a certain amount, a 401k may offer more benefits than you initially thought. Simply put, if you are not maxing out your 401k at work, you are missing out on potential money.

It can take years, and even decades, to establish a sizable 401k. With something that you have dedicated so much time an effort to, you would be smart to protect it. Many times, workers who are not approaching retirement age think they can borrow money from their 401k with little long-term effects, because of their young age.

How a 401k Loan Works

In actuality, borrowing from yourself at such a young age can stunt the growth of your portfolio. The time you have money withdrawn from your account is lost time that your investments could be growing and compounding. Instead, your money is withdrawn and stops making you money; it actually starts costing you money.

There are laws in place on the amount you can borrow from your 401k, along with the repayment terms of that loan. You are allowed to borrow up to $50,000 or 50% of your current 401k balance, whichever amount is smaller, that is your borrowing limit.

There is interest charged on any loan you take from your 401k. Usually, the rate is just a few percentage points higher than the prime rate, but rates can vary some.  In the end, any interest paid will be going back into your 401k, making yourself the recipient of the interest.

Paying interest to yourself may sound good in theory, but there are still risks you must keep in mind. If you lose or change jobs, you will have 90 days to repay the loan or face an additional 10% penalty. So, not only would you lose your job, but you will also have damaged the security provided by your 401k.

Why You Should Think Twice About a 401k Loan

While a 401k can provide many benefits and is a great choice for building a retirement portfolio, it is still your money to make decisions with. You have the option to take out a loan from your 401k, and if it is a last resort, that may be acceptable. However, it’s only worth it in a truly last resort scenario.

In the event that you have no other option for money that you desperately need, you may be forced to opt for a loan from your 401k. Many times, workers borrow money for emergencies and then pay it back with interest relatively fast. In these examples, the drawbacks of a 401k loan would be minimized.

But, if you make a habit of borrowing from your 401k, or when you borrow from your 401k you have difficulty repaying the loan in a timely manner, the effects will start to materialize in the form of poor portfolio performance.

Final Thoughts

In the end, you yourself will be the one hurt down the line when you need your 401k. If you are considering borrowing money from your 401k, understand the risks you will be exposed to, along with possible alternatives you may have. From the potential investment gains you will miss out on, to the risk you are assuming if you lose jobs, the risks could very well outweigh the benefits of a 401k loan.

Before making any financial decision, especially one of such magnitude, you should carefully research and verify a 401k loan is truly the best option for you.

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