401(k) Loans and Why They are a Bad Idea

There are companies that will allow you to withdraw a loan against your 401(k) plan. It might sound like a brilliant idea for a new car or whenever you are planning to borrow money. You borrow money from yourself and pay yourself back, not a bank, with interest. Below are some things to consider.

FACTS:

1. First of all, if you need a loan, maybe you don't need to buy what you are thinking of buying. Your emergency fund should cover any real emergencies. You should save up for a car so you can buy it out right by making payments to yourself for the first 3-5 years of your auto ownership life, etc.
2. Some companies are not able to give you a loan from a 401(k).
3. Most have a minimum amount that you are required to take out such as $500-$1000.
4. If you are able to borrow, you should be allowed to borrow up to 50% of your vested balance and up to $50,000.
5. The term is generally 5 years, however, if a loan is used for a mortgage, you might be able to take out the loan for 15 years.
6. Typically, the interest rate that you pay back to yourself is prime plus 1%.
7. Payments are set up for automatic withdrawal from your paycheck.
8. There are usually loan and origination fees.

WHY IT'S A BAD IDEA:

1. There are origination and loan fees.
2. The interest that you will be paying yourself back will probably be less than the amount that you would have earned through market gains.
3. If you default on the loan, it will be counted as a distribution. Therefore, in addition to the regular taxes that you have to pay, there will be a 10% penalty fee on that amount. You also loose that money from your 401(k).
4. When you pay back the loan, you use your tax dollars to contribute to an account that should help to shelter your income. Therefore, you will be taxed twice. Once, when you repay the loan and then again when you pull that money out in retirement! Although, if you look at all of your money and not just the 401(k), you did take the loan and never paid taxes on that money, so when you are repaying the loan with taxed dollars, you are simply paying postponed tax on the the original loan amount.
5. If you quit your job or are fired, you typically have 60 days to repay your loan balance in full or the remaining balance will be considered as an early distribution causing you to be taxed on the amount. You will also have to pay a 10% penalty on the remaining unpaid loan balance.
6. The biggest factor, in my opinion, is that you cannot contribute to your 401(k) until the loan is fully repaid. This provision makes you miss out on the compounding benefits of retirement accounts and the employer match AKA free money.