The Coronavirus Aid, Relief, and Economic Security (CARES) Act made it easier for Americans to borrow money from their 401(k) accounts by doubling loan limits from 50% of your vested account balance or $50,000 max, to 100% or $100,000 max if you're facing financial hardship related to the coronavirus.
But just because borrowing is easier doesn't mean it's a good idea. In fact, 401(k) loans are almost never a wise financial option, and they're an even worse one this year for three key reasons.
1. You could end up owing a penalty if you can't repay the loan
If you do not repay your 401(k) loan on schedule, the defaulted loan is classified as a withdrawal, which has serious consequences. You're taxed on your withdrawal at your ordinary rate, and if you're under age 59 1/2, you will also owe a 10% penalty.
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The CARES Act created special rules for 401(k) withdrawals in 2020, allowing up to a $100,000 distribution without penalties and enabling you to pay the ordinary income taxes due over three years. Unfortunately, a defaulted loan won't convert to a penalty-free withdrawal. The normal consequences apply if you don't pay back your loan on schedule.
Because of the higher costs associated with a defaulted loan, it may make sense this year to take a distribution instead of borrowing. That's especially true as the CARES Act allows you to pay back withdrawn funds over three years (and avoid owing taxes on them if you do) without any impact on eligibility for future contributions.
2. You could be stuck at your job or risk having to repay quickly
Many people are facing uncertainty regarding their careers right now as the unemployment rate is still near record highs, another COVID-related lockdown could happen, and many schools have gone virtual and created complications with child care.
That's a problem if you're considering a 401(k) loan since leaving your job typically accelerates the loan repayment process. Generally, you'll need to repay the entire balance by tax day in the year you took the loan or you risk having it treated as a withdrawal. That would mean the penalties and tax consequences mentioned above apply.
It can be really difficult to repay a loan after losing a job, especially if you've taken advantage of the higher limits under the CARES Act and borrowed a substantial sum.
3. You'll miss out on gains you could have earned
Although you do repay a 401(k) loan with interest, chances are good you could have earned a higher rate of return if you'd left your money invested. Sadly, you'll miss out on the gains you could have made during the time you're repaying the loan. And if you never pay it back, you'll miss out on all of the money your investments would have earned between the time of the withdrawal and your retirement.
The consequences of this could be worse if you end up selling investments at a loss when you borrow and you miss out on the economic recovery if it occurs during your payback period, meaning you buy back in when stocks are at a higher price. And with the market so volatile right now due to the coronavirus, the chances of this occurring are higher than normal.
You don't want to end up with a retirement account balance that's substantially smaller. So, unless you've exhausted all other options, just say no to borrowing from your 401(k) plan.
