The Hidden Dangers of Borrowing from Your 401(k) Plan

by Murray Coleman - Tuesday, 26 December, 2023

When faced with mounting debt — or even a rather large and unexpected expense — it's not uncommon for some cash-strapped workers to consider dipping into their 401(k) or 403(b) retirement savings nest eggs.

After all, the money is theirs, so why not use it to ease financial burdens or treat oneself to a well-deserved vacation?

At IFA, however, we feel a responsibility to point out that borrowing from retirement accounts can have far-reaching consequences — and ones that can potentially compromise a retirement saver's long-term financial security.

While taking a loan from a 401(k) or 403(b) plan is not always a bad idea under certain circumstances, as fiduciaries to our clients we feel an obligation to help retirement savers understand the potential risks and drawbacks associated with such loans. Below are five key suggestions to consider before making any concrete decisions.

Tip #1: Missing Out on Your IFA Portfolio's Growth Potential

We can't emphasize this enough: Taking a loan from a retirement account can lead borrowers to remove their money from the market, thereby losing out on potential investment gains and the benefits of compounding interest.

The longer the loan term, the greater the potential loss in investment growth. This missed opportunity can negatively impact one's retirement savings and overall financial health.

Just a slight reduction of contribution levels over an extended timeframe can severely hinder one's ability to accumulate sufficient retirement savings — thereby jeopardizing a retirement saver's long-term financial security.

Tip #2: Watch Out for Double Taxation

One of the major downsides of borrowing from a 401(k) or 403(b) plan is the double taxation that occurs on the loan's interest payments.

When repaying the loan, the interest is paid with after-tax dollars, meaning that borrowers effectively pay taxes twice on the same amount of money. This double taxation can significantly increase the overall cost of the loan, making it a less attractive option compared to other sources of financing.

Tip #3: Check the Fine Print

Does your plan allow additional contributions to be made before loan obligations have been fully met? Some 401(k) and 403(b) plans include language that prevents those taking loans to make new contributions to their retirement accounts until their outstanding loan balance is repaid.

This type of a restriction can have a threefold impact on borrowers' finances: reduced retirement savings, missed employer-matching contributions and increased taxable income due to the absence of pretax deferrals.

Even if your plan does allow for contributions to continue during the life of a loan, the added complexity of keeping up with 401(k) or 403(b) debt repayments might cause you to limit — or miss — your regular savings schedule. That can lead to missing important investment growth opportunities through a globally diversified and passively managed IFA portfolio of index funds.

Tip #4: The Threat of Job Loss

Another major risk associated with 401(k) and 403(b) loans is the requirement to repay the loan in full by the time you leave the company where your loan was initiated.

For example, it's common for plans to stipulate that borrowers have 90 days to repay the outstanding loan balance after their employment ends. If the loan is not repaid within this period, it likely will be considered by the IRS as a taxable distribution — meaning it'll be subject to income taxes. In many cases, if the borrower is less than 59 years old, a 10% early withdrawal penalty will also be assessed.

This requirement can put borrowers in a precarious financial position if they lose their job unexpectedly or decide to change employers. In such situations, coming up with the funds to repay the loan can prove rather challenging. It's important to note that defaulting on such a loan can result in substantial financial penalties.

Tip #5: Ask for Advice Before Signing a Loan Contract

Despite the risks and drawbacks associated with borrowing from retirement accounts, in some cases taking a 401(k) or 403(b) loan might turn out to be the best available financial option. To determine if dipping into your retirement savings is a good idea, IFA urges plan participants to take advantage of an objective set of eyes to help look at your unique financial situation.

Before borrowing from a retirement account, savers should carefully evaluate their financial needs and explore alternative sources of financing. If the loan is determined to really be the best option, borrowers should be prepared to repay it diligently and promptly. This means prior to making a final decision, borrowers need to develop a detailed repayment plan and consider how this might impact making regular contributions to their retirement accounts.

The ultimate key to long-term financial success lies in disciplined saving, prudent investing and careful planning. By resisting the temptation to borrow from retirement accounts and focusing on building a solid financial foundation, individuals can enhance their financial well-being and secure a comfortable retirement.

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.