8 Reasons to Never Borrow from Your 401k Retirement Plan

(March 4th, 2008)

According to a study conducted by the Employee Benefit Research Institute in 2005, 20% of all 401k investors who were eligible for borrowing from their 401k plans (taking out 401k loans) did so. The average loan option exercised in 2004 was $6,946 which is about 1/2 of the average debt of households in America (excluding mortgage debt). The $6946 figure represents the following percentages of peoples' total retirement savings.

As you can note from above, as the person gets older, he has more retirement savings and tends to borrow less from his/her 401k plan. However, people in their 40s borrow about 2% more than people in their 30s, anyone have a logical explanation for this? Post your comments below if you do! And while it is good that as the person gets older, he tends to borrow less, it is not advisable to borrow from your 401k at all! We will go over 8 major reasons why you should never borrow from your 401k.

Some financial advisors might tell you that borrowing from your 401k is better than using your credit cards or taking out a commercial loan with higher interest rates. They also say that when you repay your 401k loans, you will be repaying interest to yourself, and not some bank. While this is partially true, in the long term, you would be way better off accumulating your savings and gaining compound interest, rather than reducing your principal amount by borrowing money from it.

1) Your Savings Growth is Reduced

If you take out a 401k loan, most plans have a provision that you cannot make any more contributions until a certain percentage of the loan is paid back. Some plans may even have a provision that states that 100% of the loan amount must be repaid! Added to that, even if your plan does not have a repayment provision, you may not be able to afford to keep up with your 401k loan payments and make additional 401k contributions (that you were supposed to make every month anyways). This significantly reduces your ability to grow your 401k savings. The whole point of 401k plans is to save for your retirement, by withdrawing any amount of money from it, you are really defeating the purpose of the plan!

2) You Are Losing Money

Every monthly contribution that you miss also misses the growth & appreciation that is available from the stock markets, bond markets as well as commodities futures markets. Furthermore, you are also missing the power of compounding interest on your total principal balance. The low interest payments that you are paying to yourself is likely to be insignificant compared to the appreciation & returns on investment that is available in stocks/bonds/commodities markets. Also, the money you are paying yourself will be after-tax. For every $1 you earn, your ability to repay the loan will only be $0.78 (considering you are in the 22% tax bracket). Also, that $0.78 that you have to repay yourself will be taxed AGAIN when you retire and withdraw your money from your 401k. You are pretty much getting beat down by the double taxation & losing the power of compounding interest, you do not want that!

3) Time is Not In your Favor

By making monthly contributions to your 401k, the idea is that over the long term, your money will grow substantially and accumulate the power of compounding interest. Compounding interest calculators state that your money will double every 8 years if you invest diligently and with discipline. Most 401k plans allow loans to be held for up to 5 years. If you used a 401k loan to purchase your home (or finance for a down payment on the home), you are losing the ability to double your money in 8 years average. What's more, you will lose the power of making additional contributions & more growth opportunities & returns on investment. Over time, your 401k balance will never reach its maximum potential and the greatest sum of money you could have had!

4) Unable to Repay the Loan? More Trouble!

If you get yourself in a situation where you cannot repay the loan, it will be considered a taxable withdrawal and you will be subject to income taxes. This is in addition to the 10% early withdrawal penalty you will have to pay for your withdrawal.

5) Quit Your Job? Repay the Loan!

If you quit your job with your current employer, the 401k plan administered by your employer will require you to repay it immediately! Thus if you have a 401k loan, you will be stuck at your current job for as long as you do not repay the loan. This is because if you quit, you will have to come up with the cash to repay the loan. If you do not have that cash, you cannot quit your job. This might require you to pass up a better opportunity where there's more pay, challenge and career enhancement.

6) No Financial Cushion

You should borrow a 401k loan in the toughest of circumstances where you really have NO other source of funding, no family, no relatives, etc. If you borrow a 401k loan to pay off your credit card debt or to fund an exotic vacation, this money will NOT be there when you really need it in the toughest of circumstances. That is why we say, do not borrow from your 401k!

7) Living Beyond Your Means?

If you need to borrow from your 401k, this automatically creates a red flag that you are living beyond your means. If you cannot find any other way of making money other than borrowing from your 401k, you should revisit your spending habits and see where you are blowing up excess money.

8) Violates the King Rule of Personal Finance

Borrowing from your 401k violates the very important saying of "Pay yourself first." It is definitely a bad idea to violate this rule.