Why to avoid 401(k) loans

Too many people view their 401(k) plans as this incredibly tempting pile of money available to them when the moment strikes. Sometimes a moment is for the silliest of short-term reasons, such as the "need" to buy a much nicer car.  Other reasons appear more rational, such as when the money seems like the only source of funding after a job loss.

No matter the reason, raiding your 401(k) plan should be near the bottom of your list of places to raise cash.  Distributions from a 401(k) plan are immediately taxable and, with very few exceptions subject to a 10% early distribution penalty if the accountholder is less than 59 ½ years old.  Furthermore, most states will also tax any 401(k) distribution. Taken together, it is not uncommon for the distribution check you receive to be 40% less than the amount you see deducted from your statement.  Critically, a much larger amount will be forever reduced from your account in the future, as the money you distribute and spend today will not be available to grow for your retirement.

A 401(k) loan sounds better than a distribution since you can pay it back.  Indeed, it is preferable. But a 401(k) loan, while not subject to the taxes and penalties mentioned above, is determined to be so if you are unable to pay it back according to the schedule.  Keep in mind that the schedule could change, especially if you are laid off or wish to change jobs. In either of those cases, you could have as little as 60 days to repay the entire amount or face interest and penalties on the distribution of money that, in all likelihood, you no longer have.