The pitfalls of borrowing from a 401(k) plan are the following opportunity costs:
–Borrowers lose any positive earnings that would have been produced by those investments in the market. In other words, the impact is negative in strong ‘up’ markets.
–Many borrowers either stop contributing to their 401(k) or reduce their contribution for the duration of their loan, so they also miss out on the company match.
–Unless the money is repaid quickly, the loan represents a permanent setback to retirement planning.
–Borrowers lose out on tax efficiency. Loans are repaid with after-tax dollars. In other words, someone in the 25% tax bracket would need to earn $125 to repay $100 of the loan. The 401(k) money is taxed again when withdrawn in retirement, so those who take out a loan are subjected to double taxation.
— Double taxation of 401(k) loan interest becomes a meaningful cost when large amounts are borrowed and then repaid over multiyear periods.
–The first 401(k) loan can act as a “gateway” to serial borrowing.
–The interest borrowers save by choosing a 401(k) loan over a bank loan still might not be enough to make up for the loss of earnings from taking the money out of the 401(k) account.
–There may be a loan origination or administration fee to tap into a borrower’s own 401(k) money.
–A 401(k) loan can become a serious problem without having the intent or ability to repay it on schedule. In this case, the unpaid loan balance is treated similarly to a hardship withdrawal with negative tax consequences and perhaps also an unfavorable impact on plan participation rights.