Updated: Aug 17
Borrowing from a 401k retirement account is generally allowed by retirement plan providers. While 401k loans can be a quick source of emergency funds and can provide immediate financial relief, they can be very costly when considering the drawbacks.
A major cost of 401k loans is the missed opportunity cost of keeping your savings invested in the market. You will miss the tax advantages of a company-sponsored retirement account and the compounding interest on a tax-free investment.
There are additional negative tax implications for 401k loans. Repayment on a 401k loan is made using after-tax dollars, while the funds are borrowed from a tax-protected investment account. Your payments will come from money taxed at your marginal tax rate, adding hidden cost to your loan repayments.
Lastly, there is the unforeseen risk of leaving your job with a 401k loan outstanding. If you leave your job with a 401k loan outstanding, you may be required to pay back the loan in a short time frame. If you are unable to pay off the loan, the loan will be considered defaulted and will be treated as a withdrawal or distribution, which creates tax liability. You will owe taxes and will be subject to a 10% federal tax liability if you are below 59 ½ years old.
401k loans can be a viable option if you need access to funds or are experiencing an unforeseen financial hardship. Before borrowing from a retirement account, consider other alternatives with less risk, such as a personal loan or home equity line of credit.