I had a question posed to me this week about 401k loans, and whether they were a good idea. The person said they were considering using a 401k loan to pay off some higher interest credit card debt. The rationale behind doing this was that they'd rather pay themselves interest than the credit card company, and that the interest on the 401k loan was lower as well.
In some cases taking out a 401k loan can seem to make sense, and I wasn't quite sure what to tell this person. I felt like there might be some hidden reasons that it wasn't the greatest plan.
After doing some research on the topic I found that many experts frown on these types of loans.
There are a variety of risks inherent in taking out 401k loans, and you can end up losing a lot of money if something goes wrong (You know what they say about that – usually whatever can go wrong, will).
Here are a few of the reasons why you should think twice about getting a 401k loan.
Reasons To Think Twice About A 401k Loan
- If something happens and you quit or get fired from your job before the loan is paid back, you will be obligated to pay it back immediately or suffer the fees and penalties associated with a 401k withdrawal. (your tax rate plus 10% penalty – up to 40% or more sometimes). Often times this is the time you can least afford to pay it back! Many plans have a 60-90 grace period to pay the loan back after you leave your job.
- The money is essentially taxed twice because you're paying 401k loan back with after tax dollars, and then you're paying taxes again at withdrawal at retirement.
- The money from the loan can be treated as taxable income if the loan goes into default, which may end up bumping your tax bracket up and costing you even more in taxes.
When it comes right down to it Dave Ramsey said this:
Never, ever borrow on your retirement. In an emergency like owing the IRS or facing foreclosure, you can withdraw some. You’ll still get taxed, but don’t borrow against it.
I can see how someone might be tempted to take out a 401k loan. On the surface it seems like a good deal. But when you examine the risks involved with taking one of these loans, often you're probably better of just setting up your debt snowball and getting “gazelle intense” and just paying off the debt as quick as possible.
There are some situations where I might actually consider taking out a loan or early withdrawal, like in a situation where you may end up losing your house, but it would have to be a pretty dire situation in deed. Weight the risks involved – with the risk of not taking it out and make the best decision for your family.
What do you think about 401k loans? Do you think they're ever a good idea? Would you or have you ever taken one out? How did it work out for you?