To help people meet their financial obligations during the pandemic, the CARES act expanded 401(k) loan limits. Just because the option is available, doesn’t mean it’s smart to take it. The legislation may be well intentioned, but a 401(k) loan should be used as an absolute last resort.
Here are three ways a “K-plan” loan can backfire:
- Tax Consequences – While you have up to five years to repay the loan, if you lose your job or change employers, the loan has to be paid back by the filing date for the next tax year. If not, the outstanding balance is taxed as ordinary income. If you are under age 59.5, you’re hit with an additional 10% early withdrawal penalty. To add insult to injury, the loan would be paid back with after-tax dollars. This means you are effectively taxed twice, once on the dollars that are repaying the loan, and again, when you take distributions.
- Market Timing – In the current environment, taking a loan from your 401(k) is selling low, and likely buying higher in the future. You may think you are taking a loan, but you are really market timing with your retirement dollars. Over a five year loan repayment period, we would expect the market to be higher, which means you’re selling low today and buying higher in the future – just the opposite of how we make money!
- Loss of Compounding – With less money in your plan, there is less money available to compound. Your repayments rebuild the 401(k) balance. To contribute tax-deferred dollars to your plan, you’d effectively have to make double payments (your regular payments and loan repayments). However, if you have to take out a loan in the first place, you probably don’t have the free cash flow to make contributions while also paying back the loan. Losing out on five years of compounding would have an adverse impact on your retirement plan.
Before you consider taking a loan from your retirement plan, consider the following alternatives:
- Borrow from another asset, for example taking out a line of credit on your home.
- Take a hard look at your budget. This is an ideal time to try to reduce expenses.
- Request forbearance on student loans, mortgages, and credit cards.
Loans from your retirement accounts may sound good today, but they may cause you to work longer than you would like down the road.
If you have any questions, contact us for more information.