401k Loans
The Hidden Dangers
By Daniel Muniz

Below is a frequently asked question that I have often seen about 401k loans:

The most important thing to understand about a 401k is that it is not a savings account or a credit card although plenty of people often treat them as such.

A retirement account is your nest egg and it has to be handled with great care. Imagine the most important personal tangible item that you possess. Whether it is a baby picture, antique, love letter, stock certificate, card, or whatever, many people treat such irreplaceable items with great care and reverence. But most importantly, people often place these things like in a safe deposit box inside a bank, in a personal safe, or just somewhere for safe keeping.

That is the exact same way you should think of your own personal retirement.

Would you cash out your 401k and then take the proceeds to Vegas?

Such a move is absurd but in all reality, that is very much what other people are doing when they take a 401k loan for a vacation or for other stuff.

First off, the taxes consequences alone ought to be severe enough to scare away reasonable people.

For instance, your 401k plan is funded with your “pre-tax” contributions (either from you and/or your employer). During the course of the loan, you are paying it back with “after-tax” dollars. Consequently, when the day comes to withdraw your money for retirement, that same amount of money that you paid back into your 410k loan is then taxed again. As a result, you have been cruelly socked with “double taxation” on the same money.

Most people are simply unaware of the nasty tax bite because they tend to view such accounts as merely being another pool of money that they can access. However, the “double-taxation” that your retirement money goes through is real and it is painful.

But here is where it can get worse.

In today’s fluid and volatile job market, suppose you have to leave your employer or you get laid off, then the 401k loan remaining balance becomes due in its entirety here and now. If you are unable to immediately repay the loan, then it gets treated as an early distribution. That is, you are going to get socked with penalties such as 20% to federal government, 10% state, as well as a 10% penalty.

When you take in the tax considerations, are you fully prepared to accept a cruel double taxation on your own money when you retire?

And are you willing to risk the severe tax consequences of your loan turning into an early disbursement in case you lose your job?

In addition, the most obvious implication of a 401k loan is that you are interfering with your investments.

Yes, you could get lucky in which your plan administrator sold your shares of your 401k at a tremendous gain and then while you were paying back your loan, the same shares were bought back at a low price. But very seldom do unplanned investment decisions ever materialize in the best of circumstances by pure chance. Odds are that these transactions are going to take place during inopportune times.

But the worst part of interfering with your investments is that your money is no longer working for you. Its value has shrunk and it is unable to grow and compound at its original rate.

However, if your back is up against the wall because you are in a desperate situation, then by all means tap into that source of money. But the real question that you have to ask yourself is if you are really in a dire predicament.

Can you truly hold off for a year or two instead of getting that loan? And can you cut back on your own lifestyle to save the amount of money you need to borrow if you decided to wait it out?

There is nothing wrong with saving money from each paycheck and there is no stigma attached to spending less of your own money every day. Unfortunately, too many people think that savings accounts are for losers who do not have good credit. And with consumer spending accounting for a third of the economy, it simply isn’t fashionable to save money these days.

And here is another consideration. Suppose that you do take a loan (some plans allow for two loans) that is “not’ for emergency purposes and then a real emergency arises. At that point, you no longer have that escape hatch that would have been available for you when you needed it.

But overall, you really have to think long and hard about taking out a 401k loan. You have to examine your own personal lifestyle to determine whether or not there is no other way to safely acquire additional cash. You also have to resist the tremendous temptation to treat the loan like a savings account or a line of credit.

One friend of mine once explained:

And to tip my hat, I have taken out a few 401k loans myself; most of the time it was either for an emergency or for something truly worthwhile. However I have to admit that there was an occasion that I treated such a loan like a credit card and in hindsight I regretted it. But today I have a much better understanding about my own retirement and about my future. And that is perhaps the best way to look at the loan itself. Is it going to greatly enhance your future?

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