This week’s theme on the Retirement Quick Tips Podcast is: Top 5 Money Traps To Avoid

Today, I’m talking about a money trap that may not seem like a money trap at first glance: the 401k loan. 

The 401k loan is essentially a loan you take from yourself. You’re borrowing from your own 401k balance, and then when you re-pay the loan, you’ll pay interest, but that interest on the 401k loan, you’re paying to yourself. 

So it sounds like the loan is free and low risk. But here’s why 401k loans are money traps: 

1. They’re tempting for the reasons I just mentioned. For this reason, people who use 401k loans tend to view their 401k as a piggy bank to tap into whenever they need, not as an account set aside for retirement. Viewing it this way causes many borrowers to tap into their 401k more often and borrow at higher amounts. 

2. When you borrow money from your 401k, you’re losing out on the investment earnings you otherwise would have had if they money stayed in  hte account and stayed invested. That wouldn’t have been a problem in 2022 when your 401k went down in value, but what if you had a 401k loan outstanding in 2019-2021. The S&P 500 was up 29% in 2019, 16% in 2020, and 27% in 2021. The cost of the loan is essentially equal to those returns you missed out on while your money wasnt invested, making the real cost quite significant. 

3. You repay your loan using after-tax money. That’s a horrible financial tradeoff when most of the time, your original contributions were made on a pre-tax basis. Think of it this way: if you’re in the 24% tax bracket, you now have to work about 1/4 more to get the money back into your 401k, compared to when you made the original contributions. 

4. I work with a lot of 401k plans, so I see firsthand what people tend to do when they take a loan. And very often, they stop contributing to their 401k while they’re repaying the loan. We’re talking potentially tens of thousands if not more in a lower 401k balance because of lower or no contributions while repaying the loan. 

5. All kinds of problems if you change jobs or get laid off or fired. The loan becomes due by the time you file for your next tax return. And if you default, you’re looking at taxes and penalties on the loan.

So despite seeming attractive on the surface, a 401k loan is definitely a big money trap, and should only be used for a true emergency, and paid back as soon as possible. 

That’s it for today. Thanks for listening! My name is Ashley Micciche and this is the Retirement Quick Tips podcast.    

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Tags: retirement, investing, money, finance, financial planning, retirement planning, saving money, personal finance