In 2012, Ashley Patrick and her husband had another baby on the way. Already having an 18-month-old on their hands, they realized they needed to expand their home. The renovation would cost $25,000.
The couple didn’t have the cash on hand. After getting advice from friends to take a 401(k) loan to fund the renovation, they initiated the process. But, they thought they were using the account as collateral; when Patrick saw the balance drop, she recalls being upset.
“I didn’t realize that was how it worked,” Patrick says.
The renovation finished in August 2013; their second daughter arrived about a month later. They were making payments on the loan, but then Patrick’s husband lost his job.
Their provider notified the couple that they had 60 days to repay the remaining $20,000 of the loan. With their household income cut in half and low savings, they were unable to pay the bill and defaulted on the loan, turning it into an early withdrawal.
As a result, the couple incurred a penalty. The money was taxed as income, so instead of getting a “nice refund” like they do every year, Patrick says they received a tax bill from the IRS for $6,500.
“I don’t care if you are ‘paying yourself back’ (with a 401(k) loan),” Patrick says. “The biggest lesson I learned was to not take out a 401(k) loan, ever.”
Why taking out a 401(k) loan is a bad idea
Retirement accounts are meant to stabilize the future. As more financial responsibility for retirement falls on the consumer, the concept of retirement is changing. Some baby boomers, who have been unable to plan or save enough for their futures, worry they may outlive their savings or never retire.
However, keeping up with contributions is essential. Borrowing from a 401(k) only delays, or wipes out, retirement plans.
Sometimes, taking out a loan from retirement savings is the only option to cover unexpected costs. But using a retirement account as emergency savings comes with serious risks.
Here are five reasons you shouldn’t borrow from your 401(k).
1. You might not be able to make contributions
Some plans don’t allow additional contributions to be made until a loan is paid off.
Larry Solomon, director of investments and financial planning at OptiFour Integrated Wealth Management in McLean, Virginia, says contribution freezes hit consumers hard in two areas: contributions and tax advantages.
Plans allow $18,500 ($24,500 for those 50 or older) of pretax income to be deferred to 401(k)s. Solomon says this, combined with missing out on a match from an employer, results in a “double whammy” of missed savings.
2. You’ll be charged fees
Part of the lure with a 401(k) loan is that they’re “low” interest, but that doesn’t mean they won’t cost you. Providers often charge setup fees, annual administration costs and more. Origination fees can start at $75 and climb, depending on provider.
3. Your paychecks might get smaller
Some 401(k) plans initiate loan repayment through paycheck deductions. This means your post-tax dollars are repaying pretax money you saved, which makes it more expensive, Solomon says.
Overall, you’ll be spending more to repay the loan — and dealing with a lower monthly income at the same time.
4. Defaults can hit you (and your future) big time
Nearly 40 percent of retirement plan participants take advantage of loan offerings, and 10 percent of those loans default each year, according to a new Deloitte study. The defaults result in more than $2 trillion in potential future account balances will be lost over the next 10 years.
On an individual level, the hit is just as hard.
The study gives the example of a 42-year-old borrower defaulting on a $7,000 loan. That borrower, who is more likely to withdraw his or her remaining remaining balance of $70,000 after defaulting on the loan, will miss out on $300,000 of retirement savings over their career.
Additionally, a 401(k) loan that ends up in default is subject to income tax and a 10 percent penalty. Sometimes, a withdrawal taxed as income can even bump borrowers into the next tax bracket, reducing their tax return or even increasing their money owed come tax season.
5. You lose asset protection
One lesser-known advantage of 401(k) accounts is the protection they offer. Assets in these accounts are protected from creditors by federal law, meaning they can’t be seized even through personal or business bankruptcy. Taking money out of that account waives that protection.
How to prevent needing a 401(k) loan
Sandy Blair, director of retirement readiness at CalSTRS, says the best way to resist using a retirement account is to build emergency savings.
To build emergency savings, Blair offers these three tips:
- Increase monthly savings: Be realistic about how much you want to increase the amount by — and regularly evaluate your contributions. If you can raise your monthly savings, don’t wait to do so.
- Keep your savings accessible: Putting those funds in an easily accessible savings account will grant you easy access, should you need to pull from the fund. Additionally, those funds will earn interest.
- Replenish: Should you borrow money from your emergency fund, be sure to boost it back up to the six-month level after every use.
For those who might think emergency funds are too hard to build, as compared with the convenience of using a 401(k) loan, Blair has an easy anecdote to resist the temptation:
“Think of it as an insurance policy on your financial future.”
Alternatives to taking out a 401(k) loan
If you’re facing a financial emergency and don’t have the savings to cover it, experts still don’t recommend tapping your 401(k) for help.
Instead, consider these three alternatives:
- Personal loan: While this does mean taking on some debt, personal loans often have lower interest rates than credit cards. The advantage to using this type of loan, instead of a 401(k) loan, is you won’t have to deal with it being taxed as income or getting a giant penalty fee.
- Home equity loan: Tapping your home’s equity can be a way to avoid taking out a 401(k) loan. A home equity loan usually offers low interest rates and stable monthly payments, making them manageable while paying them back. Use these loans with caution, though; you run the risk of losing your home if you fail to make the payments.
- Negotiate with your creditors: If you’re struggling to make payments on debt, consider negotiating a payment plan with your creditors. This process can be initiated by contacting your creditor yourself or hiring a third-party source to negotiate a debt repayment plan for you.