Yahoo Finance 6 Reasons Your 401(k) Shouldn’t Be Your ATM: The Rising Trend and Risks of a 401(k) Loan
It’s no secret that inflation has made most things in our lives more expensive. Unfortunately, the price increases are straining many household budgets, causing many people to turn to their 401(k) for emergency cash.
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However, using your 401(k) as a personal ATM is a poor financial decision. Keep reading as we discuss some of the risks associated with tapping into your 401(k) to access much-needed money.
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It’s Hard To Repay the Loan Quickly
Many people who resort to a 401(k) loan borrow a significant amount of money. According to Plan Sponsor Council of America, the average 401(k) loan in 2022 was roughly $15,000.
Unless you make drastic changes to your budget, it can take significant time to repay a sizeable loan like this completely.
You Have To Repay the Loan With After-Tax Money
When you contribute to a 401(k), the money is invested pre-tax. However, when you take out a 401(k) loan, you will repay the loan with after-tax money. This means you’re losing money to taxes.
To help give you a visual, let’s assume you’re in the 22% tax bracket. For every $1 you earn to repay your loan, only $0.78 goes back into your account. This means you need to work even harder to completely repay your account to where it was previously.
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You’ll Miss Out on the Growth of the Account
When you withdraw money from your 401(k), the money won’t earn an investment return. 401(k) loans allow you to borrow money at a lower cost than many other loans, but you need to consider the cost-benefit of losing out on these investment gains.
“When you take a loan out from your 401(k), you are slowing down your retirement savings progress,” said Erika Kullberg, founder of Erika.com. “401(k)s work their magic when they have many years to put the power of compound interest to work. When you remove funds for a loan, your money can’t make you any money. Instead of earning interest, you will pay interest like you would with any other loan. Those interest payments are money you could be putting toward your future instead.”
You May Contribute Less to the Account While You Have the Loan
Some 401(k) plans have rules prohibiting you from making additional contributions until you have repaid your loan. Even if you’re allowed to continue with contributions, your budget may not allow it.
If you’re not making contributions, you’re losing out on compounding returns you otherwise would have had. This disadvantage can be even more significant if you also miss out on your employer matching your 401(k) contributions. This pause in contributions can have a serious effect on your retirement outlook.
“If one uses a 401(k) as a piggybank, one will accumulate less money in a 401(k) and when retirement comes, will be left with a stark reality,” said Robert R. Johnson, PhD, CFA, CAIA, professor at Heider College of Business at Creighton University. “Simply put, there aren’t any good options if one hasn’t saved enough for retirement. Once someone reaches retirement age and hasn’t accumulated enough retirement savings, one only has two options left–continue working or accept a lower standard of living in retirement–and neither of those options is good.”
Leaving Your Employer With an Outstanding 401(k) Loan Is Difficult
If you leave your job on your own or as part of a layoff, this can drastically affect any 401(k) loan you may have. Typically, these loans are required to be repaid within five years. However, if you leave your employer, you must come up with the money to repay the loan before your next federal tax return is due (as long as that that’s more than 60 days from your final day of work).
If you can’t repay the loan on time, it will be converted to a withdrawal, and the outstanding loan balance will be subject to income taxes at your current tax rate. Plus, if you’re younger than 59.5, you will also be subject to a 10% early withdrawal penalty on the outstanding balance.
Borrowing From Your 401(k) Won’t Encourage You To Make Financial Changes
Taking out a 401(k) loan, home equity loan, or personal loan to cover a financial emergency should not be your default option. You should have enough money in an emergency savings account to cover such needs.
If not, it should be a helpful warning that you may be living beyond your means and need to consider making lifestyle or financial changes.
The Bottom Line
You shouldn’t use your 401(k) as your personal ATM. Taking out a 401(k) loan has many financial risks and drawbacks. If you have other options, you may want to explore those before jumping to a 401(k) loan.
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This article originally appeared on GOBankingRates.com: 6 Reasons Your 401(k) Shouldn’t Be Your ATM: The Rising Trend and Risks of a 401(k) Loan
