Tapping 401(k)s Early Can Be Addictive

August 26, 2013

NEW YORK (8/27/13)--Like potato chips, 401(k) loans can prove too tempting to stop at just one.

Fidelity, which manages the 401(k) plans of 12 million workers, studied the behavior of 180,000 401(k) borrowers over a 12-year period (The New York Times Aug. 18). About 66% took more than one loan, 25% took three or four loans, and 20% took more than five loans.

Most financial experts condone limited 401(k) borrowing, particularly if it's to keep you afloat during a period of financial distress (USA Today Aug. 12). After all, it's easy to do, the interest rate is low--usually a point above prime--and you're paying back the money to yourself.

But before you tap your 401(k), consider these points:

  • Fidelity found that, on average, 401(k) borrowers reduce their retirement contributions by 2% until two years after the loan is repaid. So not only are you losing out on the compound earnings of the original borrowed sum, but also on the amount you stopped contributing in order to repay it.
  • According to calculations by Fidelity and the Employee Benefit Retirement Institute, if you took out two five-year loans in your 30s and dropped your contribution rate by 2% until two years after they were paid back, you would retire with 13.8% less than someone who didn't take out a 401(k) loan.
  • You're paying taxes twice on the earnings--the first time because the interest you're paying comes from after-tax dollars, and again when you withdraw the money after retirement.
  • If you leave your job, the loan likely will be due within 60 days. If you default, you not only owe income taxes on the amount still outstanding but also a 10% penalty if you're younger than age 59 1/2.

Given those liabilities, it might make more sense to seek a low-interest home equity loan or line of credit from your credit union before imperiling your retirement goals. That's especially true if taking a 401(k) loan leads to double--or quadruple--dipping.

For related information, read "IRA Withdrawals: The Good, the Bad, and the Ugly" in the Home & Family Finance Resource Center.

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