Reasons not to Borrow Money from your 401k

Many families and individuals have been hit hard by the recent recession.  Families that have been affected by a job loss or pay cut are looking for a way to pay their bills without having to pay huge interest charges or fees to banks. For this reason, many families and individuals have considered taking a loan from their 401(k).

A 401(k) account has become a staple of a typical American retirement plan.  These accounts allow an employee and their employer to deposit money without having to pay income taxes on it. Furthermore, the money is allowed to grow tax free while it is in the account. Taxes are owed on any money that is withdrawn from the account.

For many Americans, the balance in their 401(k) account represents everything they have saved for retirement. Because of this, many of them are hesitant to borrow money from the account, even though nearly all 401(k) accounts have this option. It is smart to be wary of this option, and it is important to know what the potential consequences are of taking a loan from one of these accounts.

To start, it is important to realize that there are a few rules governing loans from 401(k) accounts. The first one of these is that the loan must be immediately paid back in full in the event that a person loses his or her job. In today’s era of massive surprise lay-offs at many companies, this can mean financial ruin for many families and individuals.

For example, assume a person takes out a loan for $30,000 to pay off their credit cards. The money is immediately spent on paying off the cards, and the money saved by not having to make minimum payments on the cards is used to pay back the 401(k) loan. Six months after taking out the loan, however, this person is laid off. This person now must write a check for the remaining $28,000 left on the loan.

By writing the check, this person could be significantly reducing the amount they have in savings to live off of while he or she looks for a new job.  If he or she has nothing in savings, then the loan automatically converts into a withdrawal.

As a withdrawal, a person now owes the IRS taxes and penalties on the money.  Penalties are typically ten percent of the amount withdrawn, and taxes are owed on the entire balance. Many people discover that this pushes them into a higher tax bracket. If a person is unable to pay this tax bill, they now owe money to the IRS.

Even if a person is sure their job is secure, or they believe they could afford the tax and penalties, there are other risks to taking a loan from a 401(k) account.  When money is withdrawn as a loan from one of these accounts, it is paid back from the contribution the account holder and his or her employer were already making to the 401(k). This means that no new donations can be made to the account while the loan is being paid back.

Furthermore, the money that is used to pay back the 401(k) loan is taxable. Since withdrawals from the account once the person reaches retirement age are taxable, this essentially means that the money is being taxed twice.

If possible, look for another way to get needed funds instead of taking a loan from a 401(k) account. Use these loans as a last resort for money.