Please ensure Javascript is enabled for purposes of website accessibility

3 Reasons a 401(k) Loan Is a Terrible Idea

By Maurie Backman – Feb 26, 2020 at 7:22AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

When you need money fast, borrowing from your retirement account can seem like an obvious solution.

When you need cash in a pinch, it can be tempting to tap your retirement savings. After all, that money is already yours. Raiding your retirement plan means you avoid the hassle of applying for a loan elsewhere -- and possibly getting rejected.

Now if you're housing your retirement savings in an IRA, borrowing from it is basically off the table. (There's a loophole, but you really shouldn't use it.) Most 401(k) plans, though, do let you take out a loan against your balance. But while that might seem like a good solution to whatever financial issue you're grappling with, you should know that taking out a 401(k) loan is a move that could backfire in a big way.

Here are three reasons why you're better off avoiding a 401(k) loan.

Man with serious expression resting hand on chin while looking at document


1. You'll face huge penalties if you can't pay it back

Generally speaking, you get five years to pay back a 401(k) loan, which can be a reasonable chunk of time to gather the funds you'll need. But what if you're not able to repay it in time? In that case, the loan gets treated as an early 401(k) distribution, which means you'll be hit with a 10% early withdrawal penalty on the amount you removed. Furthermore, if you miss the repayment window on a Traditional 401(k) loan, you'll be subject to taxes on that sum, and that's a price you probably don't want to pay.

2. Your repayment period may be shorter than you'd think

Though you'll usually get five years to repay a 401(k) loan, if you stop working for the company that sponsors the retirement plan, you'll generally need to pay back that money right away -- usually within 90 days. Of course, if you know you're not ready to repay what you've borrowed, you can stop yourself from going out and finding another job -- that's easy. But if your company lets you go, for whatever reason, you could be stuck with a sudden large expense just at a moment when your income has fallen off a cliff.

3. You'll risk shortchanging your retirement

Odds are, you've invested the money in your 401(k) with an eye toward growth, and the best fuel for that growth is time. Any period when some of that money is not invested -- for example, because you've borrowed it -- it's not growing. And the less growth you generate, the less income you stand to retire with.

Now one thing you should know is that when you take out a 401(k) loan, you have to pay yourself back with interest. But that interest may be considerably less than the returns leaving that money invested in your account would have given you, which means you could still end up behind where you would have been when your retirement arrives.

Furthermore, if you fail to repay your 401(k) loan, the damage to your retirement portfolio could be downright ugly. Consider this scenario: You borrow $20,000 when you're 40 years old and fail to pay it back. If your 401(k) typically generates an average annual return of 7% -- perfectly reasonable for a stock-heavy portfolio -- and you retire at 65, your $20,000 loan will shrink your 401(k) balance by $108,500.

Leave your retirement savings alone

Borrowing from your 401(k) might seem like an easy solution when you need money. But hopefully, now that you're aware of the downsides, you'll find another way to cover your near-term expenses that doesn't risk robbing your future.

The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 10/07/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.