Earlier, I wrote a few posts on financial failures on our route to financial independence and early retirement (FIRE). The idea was to share that everything hasn’t been challenge-free on our route to a life of goofing off.
Today’s story isn’t patently a financial failure, but it runs completely counter to the advice that you might typical hear as you build your retirement nest egg. I can imagine seeing a headline on a personal finance site that says “5 REASONS NOT TO TOUCH YOUR 401K”. That said, we did touch our 401K – via a loan in our 20s – and it worked out very well for us.
The reason that you are not supposed to do this is that even if your employer allows loans, you might not keep up your payments back to the 401K or might lose your job before the loan is paid up. In both situations, the loan would trigger either an immediate payback (which you probably wouldn’t have the $$ for), or be considered a 401K withdrawal which incurs a sizable penalty (10%) and immediate tax-event (30-50%). This would mean that much of the amount you have been saving up for retirement would be forfeited to the government before it can grow.
We were aware of these risks when we took a $10K loan from my MegaCorp 401K when we were in our 20s. We had a bit of credit card & student loan debt leftover from college and had our sights set on buying our first house. To accelerate our ability to make a house down payment, we took a loan from my 401K with 6.5% interest terms. It was a large portion of our 401K balance at the time and had we not been able to keep up with it, it probably would have wiped out a few years 401K savings.
The great thing about it though was that we used half of it to wipe out our debts – which had a lot higher interest rate than 6.5% – and were able to shift the investment into a house that we could enjoy everyday. We probably would have waited a year or two more to be able to achieve those two goals. Even though it was ‘debt’ – it was a debt to ourselves and I felt better about it at the time.
While I would be hesitant to encourage my own son to do the same trick when he is in his 20s, it did work out very well for us. The repayment was simple since MegaCorp pulled the money directly from my paycheck (which was going up each year). I think the term of the 401K loan was supposed to last 5 years, but we paid it off a year or two early out of an annual bonus. While I felt like I dodged a bullet when it was completely paid off, I did end up working for that MegaCorp for 24 years in total, so I had plenty of time to pay it off. Few people work that long for a company now a days.
What has been your experience with your 401K – have you stayed hands-off?
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MrFireStation 
Great article Eric.
My understanding is that loan interest also goes back to your 401k when you pay it back. It should work in your favor more assuming one is deciplined about the repayment.
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Yes, for us it did – so in a sense you were acting as your own banker. It comes with risks, for sure, but worked out for us.
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I work in HR and we just had a meeting about our tracking of these 403B loans. My company has about 1100 employees. Many take a 403B loan, pay it off, then take another one. It is off topic, but a nightmare for reporting. Anyway, it is a bad practice on an individual level as you wrote.
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We took the loan just once, but I guess it is not surprising that people get into the ‘routine’ of taking them over & over. At our MegaCorp, you could only borrow up to a percentage of your contributions and couldn’t touch the employer match, even if you were vested.
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Good job paying that loan off early. I think it was a smart move because you had the discipline to pay it off and stop borrowing.
I never considered borrowing from my 401k because I didn’t have debt. It’s just easier to not touch it.
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100% hands off policy for me and the wife. The same with our IRA’s. If we had to, we can tap our taxable accounts. But we haven’t had to do that since we’re a dual income household. We’re able to cash-flow whatever comes up. And if it’s a bigger thing, we plan it out in advance with actionable-saving.
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Hands off the 401k/IRAs is the right policy, indeed! We ‘got away with it’ – but I wouldn’t recommend it.
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I’ve never touched my 401(k) because when I was young and had debts in the family I was addressing, the 401(k) was too small to make a real dent in the debts so it wasn’t worth the risk. Also the debt I was taking on wasn’t even mine so it would have felt doubly foolish to go into actual debt myself to pay off my parents’ loans and risk losing the growth or incurring fees if I slipped up on self repayment. It’s not likely that I’d stop repaying myself but those were difficult years financially and I was very risk averse.
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Yes – it would especially precarious to be taking on debt for other people. Good to keep your hands off!
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I was on the committee that managed our 401k at work and as such had to approve the loans to employees. Your experience to use such a loan wisely was a rare exception but then you are an uncommonly committed and successful person. I’d still advise most people not to do what you did, because most people aren’t so focused and so in control of their spending but there are always exceptional people who can take the exceptional path safely. Very informative that you shared that, and widened my perspective. thanks.
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Thanks for your comment, Steve. I forgot that there was a approval process at our company that was needed to get the loan from the 401k. I’m sure you saw some ‘interesting’ cases in the applications!
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What was tragic is that usually people were borrowing to get the down payment on a $50,000 truck or a $40,000 bass boat or both. And these people were nowhere near where they needed to be for their age in terms of retirement investing. I’m early retired and have plenty of money, but only because I didn’t buy those trucks and boats then. Now I fish every week in my modest truck with my modest boat which I bought with cash and can easily afford. I cringe thinking of the train wrecks in so many of my friends’ futures. These are nice people I used to work with but they aren’t thinking ahead and I don’t see how they will avoid financial hardship later.
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That reminds me of a time I made a series of presentations at some manufacturing plants. The folks in the plant were working seven days a week and long shifts to keep up with demand for a hot new product we launched. I said to the plant manager – boy, that must be really hard for them to work so many overtime hours, isn’t it? He said, at first it is… then they use the overtime money to put a down payment on a truck or a boat, and then they want to work the overtime as much as they can get, for as long as they can get, to keep up with the payments. Ouch!
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I borrowed money from my 401K in my 20s too, to help with a down payment on our home. I was with my company for 20+ years so never worried about paying it back. That’s the rub nowadays, like you said, not too many employees stay that long with companies, certainly early in their careers.
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The toughest thing would be to take a 401k loan and then lose your job. The taxes & penalty would be really disastrous. Worked out for both of us – a good break!
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I borrowed $20K once from my 401k to refinance my mortgage down to an equity level where I could avoid PMI and get a much lower interest rate. I paid it back over 10 months, during which time there luckily wasn’t significant market appreciation. Since I had been doing maximum contributions into 401K going back several years, this just happened to be where my most liquid assets were sitting. I consider it a smart transaction that worked out beautifully. It was simply a transfer of $20k from one asset to another to take advantage of an opportunity for a better return. I believe that maxing your 401k is actually a good place to store your extra cash, and taking a loan from yourself (if necessary) is a better option than from your bank. I also believe that the tax benefit of the 401K is such a good deal, that you should max it out each year before you invest in anything else.
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Used wisely – as in your case & mine – a 401k/IRA loan can be useful. It is a financial failure for many people who get caught up in other issues.
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10% penalty and a tax of 30%-50%! That’s enough to scare anyone away from a 401k loan. I’m glad you had the job security and it worked out for you. At the end of the day FIRE is achieved by reducing the interest rates and increasing those returns. Nice article!
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Thanks for the comment – yes, getting debt to zero is the best approach!
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That’s why I like the Roth IRA contribution rule. You can withdrawal contributions tax free at anytime. Can come in handy for something like this, rather than taking the risk of taking out a loan from your 401(k).
Sometimes rather than maxing 401(k) first it can be a good idea to add contributions to a Roth if you’re under the income limits.
Awesome that it worked out for you though! Great article, thanks for sharing.
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That’s a good strategy for liquidity – especially if you’ve already locked in your company’s 401k match.
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