Question: Would you take out a loan that, if you lost your job, would have to be paid back right away or you would be charged about 40% “interest”?* No? Then don’t take out a 401(k) loan.
“Wait a second,” you may say, “401(k) loans don’t work exactly that way!” You are so right. There’s more to it than that. Let’s explore!
First, 401(k) loans are very seductive. Here you have a nice, tidy pile of money, and all you have to do to take it out is fill out a simple form. It’s easy to pay back, since you will cover the payments by a direct deduction from you paycheck. Why, you can even pay yourself interest! What’s not to like?
There are serious risks. What happens if you lose your job? In most plans, you must pay back the balance of the 401(k) loan in 60 days**, or they will treat your loan as a withdrawal. So, if you have a 401(k) loan, do you have a plan in place to pay it all back in 60 days if you lose your job?
What’s so bad about treating your 401(k) loan as a withdrawal? Well, remember, you just lost your job. Most people are not getting another one right away, and unemployment is usually not enough for most people to live on. So, here you are in a big cash crunch, probably living on savings, and now you have a big bill. Well, if you don’t pay the bill, the IRS will treat your loan as a withdrawal, so they will ask you to pay taxes and (depending on your age) a 10% penalty. So, if you’re in the 25% federal tax bracket and you have a 10% penalty, you get 35%. Add to that an estimated state income tax of 5% and now you’re paying about 40% tax on money you probably already spent, while you don’t have a job. Oh, and by the way, you’ll owe the IRS and state revenue office this money. These people are not pushovers. This is what I like to call a “bad thing.”
As far as I’m concerned, this risk alone is reason enough to not use a 401(k) loan if it can possibly be helped. Of course, you’ll want to talk to your own financial planner before making any decisions, but I wager that your financial planner will get the heebie-jeebies just like I do.
*IMPORTANT: The amount you would pay would depend on your tax bracket. The “interest” I’m talking about here is what you would pay in taxes. I refer to it as “interest” because it’s helpful in comparing cost of funds from various sources.
**THIS IS VERY IMPORTANT: Check the language of your specific plan and speak to your HR person for details. I’m speaking to many but not all of 401(k) plans in this case, but always check your own plan rules.