Quick refresher: your 401(k) is an account provided by your employer in which you can save money for retirement. That amount you choose to save gets the advantage of being tucked away before you pay taxes on it. This is a great deal because if you want to save $10,000 in a year, you have to earn no more than $10,000. Whereas, if you wanted to save $10,000 a year into your savings account, you’d have to earn $12,500 (assuming a 25% tax rate) of which $2,500 would disappear in the form of taxes. That in and of itself, makes your 401k a great place to save. Another common perk is that your employer may choose to match a portion of your contribution, which we also suggest maximizing (a.k.a. take all the free money you can get).
Today, we are talking about whether or not you should take a loan from your 401(k) for your wedding or other non-essential emergencies. To cut to the chase: we are highly against taking a 401(k) loan unless you are in a dire situation and even then only as a last resort i.e. you have no other savings or borrowing options and are potentially staring bankruptcy in the face. Yes, that dire.
WHAT IS A 401(k) LOAN?
A 401(k) loan is an option to borrow money from your 401(k) (usually 50% of your balance up to $50,000). You repay the loan over a period of time, typically 5 years, via payroll deductions (no doubt convenient). You also pay interest on the loan which goes into your 401(k) as after-tax contributions. Yes, after tax – erasing the pre-tax benefit typically associated with 401(k) contributions. But that’s nothing compared to the other ways in which you’ll pay a price.
…BUT I’M JUST BORROWING FROM MYSELF
In theory, you are borrowing from yourself but, and this is a big BUT…in doing so, you create a chain reaction of negative consequences that are very hard, if not impossible to overcome. That is why, if advised properly, people who tap their 401(k) will only do so as an absolute last resort. The danger emerges because the massive disservice caused by a 401(k) loan is not immediately apparent, making it pretty easy to ignore.
THE REAL COST OF A 401(k) LOAN
When you borrow from your 401(k), you’re not really borrowing from yourself, you’re robbing your future self *cue dramatic sound bite*. Here are a few of the costs:
You lose free money: While repaying your loan, it’s likely you won’t be making new contributions to your 401(k). If your employer matches, you will miss out on all those contributions and can never get them back. This could cost your tens of thousands of dollars over the life of your contributions.
You are double-taxed: Whether or not your 401(k) loan is subject to double taxation is a highly debated topic. Here’s how we see it. Technically only your interest is taxed twice (once upon contribution and again when you use the money at retirement). But that’s not to say you won’t lose the benefit of a tax-deferred contribution in the first place if you tap your 401(k) for a loan. In researching this (it made our heads spin), the conclusion was that you’re no worse off taking a loan from your 401(k) (FROM A TAX PERSPECTIVE) than if you take a loan from anywhere else, but you are better off (AGAIN, FROM A TAX PERSPECTIVE) not taking the loan in the first place. Yeesh – the semantics of it all – ain’t nobody got time for that.
You give up growth/compounding: Okay, this is the one that really bothers us. You’ve likely heard us harp about how time is the most important thing to help your money grow. We often tease that we don’t like taking on clients in their 40s because we don’t like delivering bad news – we are cheeky bastards! But the truth is the only way to make up for lost time in the market is to save more…which becomes more painful the longer you wait.
You may have to pay it back immediately: The typical repayment on a 401(k) loan is 5 years, but if you leave your job early or get fired, you usually have 60 days to pay it back. And if you can’t? The remaining balance is immediately subject to taxes and penalties – way to get kicked while you’re down.
Your tax bill may go up in the meantime: While you’re paying back your loan, you probably aren’t able to contribute new money to your 401(k) and therefore aren’t able to shelter any of your current income from taxes. That means, your tax bill will likely go up during the loan repayment period.
You’re setting up bad habits: 1 in 2 people who borrow from their 401(k) become serial borrowers. Now listen, all of our clients will tell you that we think your wedding is as important as you do, but so is starting married life off on the right foot – especially when it comes to your finances. After all, your wedding is one day, but marriage is a lifetime. We advocate for working together as a team to come up with more reasonable solutions like postponing your wedding to save up for the amount you need or starting a side-hustle to bring in the additional funds faster to pay for the wedding of your dreams.
YOUR 401(K) IS NOT FAST CASH
Bottom line, your 401(k) is specifically designed to help you save for retirement. Thinking of it any other way (including to purchase a home) is counterproductive to your retirement savings efforts and very unfair to your future self – who will pay the real price. It may sound harsh to say, but if you want to be a H.E.N.R.Y.™, you have to start thinking like one. So before you think of tapping your 401(k) for non-essentials, make sure you’ve exhausted all other sources of liquid savings you can go to first.
If you’re SUPER disciplined (and we don’t make this rec lightly) you could even consider a 0% credit card AS LONG AS you have a foolproof plan for how to pay it back before the teaser rate ends. And word to the wise, never borrow the max amount you’re eligible for – it’s a slippery slope.
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