5 Reasons You Shouldn't Rely on Your 401(k) Loan to Pay Off Your Debt

Think twice before borrowing from your 401(k).

You may have heard that taking out a loan from your 401(k) can be a great way to pay off debt. While this can be true under certain circumstances, it is important to understand the risks involved in taking out a 401(k) loan and why it may not be the best option for everyone. Before you make the decision to borrow from your 401(k), here are five reasons why you should think twice.

1. You lose out on potential earnings

When you take out a loan from your 401(k), you are essentially borrowing money from yourself and therefore missing out on potential earnings. When you borrow from your retirement savings, your withdrawal amount reduces the amount of money invested which could have grown with compound interest. Depending on how long you hold the loan and how much it's worth, this could mean tens of thousands of dollars lost in potential earnings, hurting your chances of meeting your financial goals.

2. You risk owing more if you lose your job

When most people take out a loan from their 401(k), they don't factor in what would happen if they were laid off or lost their job. If you lose your job while still paying back your 401(k) loan, you will likely owe taxes and/or penalties for not repaying it within 60 days of termination. In addition to owing taxes on the entire balance of the loan due to its premature repayment, there will also be penalties assessed by the IRS if you are under 59 ½ years old at time of termination.

3. You could end up taking more loans

Taking out a loan from your 401(k) may seem like an easy solution when paying off debt; however, it could easily become another form of debt itself if not managed properly. Once borrowers begin using their retirement funds for non-retirement purposes, it becomes a slippery slope. If you see a 401(k) as a way to pay credit card bills and personal loans, then it is easy to continue doing so without considering other options such as budgeting or being disciplined and following a financial plan.

4. You may not be able to contribute more money

Another issue with using a 401(k) loan for debt repayment is that with some plans, it limits your ability to contribute to your retirement savings during the life of the loan. For example, if you take out a $10,000 loan from your 401(k), then you cannot make any contributions to your retirement account until that $10,000 has been fully repaid. This means that you may not be able to take advantage of compound growth in your retirement savings account, reducing the amount of money you will have available during retirement.

5. You only have five years to pay it back

Finally, it is important to remember that a 401(k) loan is still debt and should be treated as such. It is an extra loan that you have to pay off. This is because when you take out a 401(k) loan, the money you borrow must be paid back within five years or less. If you are unable to pay it off in time, then you will have to face significant penalties, including a 10% early withdrawal penalty and income taxes on the unpaid balance. You need to budget for your monthly payments and develop a plan for paying off the loan.

There are many factors to consider before taking out a loan from your 401(k), such as potential loss of earnings and tax implications if you're laid off or terminated while still paying back the loan. It is important to weigh all of these factors before making any decision regarding your retirement funds. Ultimately, when deciding whether to take out a loan from your 401(k), remember that this should be used as a last resort after exploring all other possible solutions.