Suze Orman says everyone should invest in a 401(k) – but never use it for this

By Ian Cooper Published Jan 20, 4:00PM EST

Key Points

401(k) loans create double taxation. You repay with after-tax dollars into a pre-tax account then get taxed again at withdrawal.
Losing your job before full repayment triggers ordinary income tax on the remaining balance plus a 10% penalty if under 59.5.
Opportunity cost equals lost market returns. An 8% annual return effectively makes the 401(k) loan cost 8%.

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Suze Orman says everyone should invest in a 401(k) – but never use it for this — © Photo by Stephen Lovekin/Getty Images

One of the worst things you can do is take a loan from your 401(k), says Suze Orman.

Remember, with a traditional 401(k), you have never paid taxes on that. Sure, when you borrow it, you’re then paying it back with 7% to 9%. But you’re also paying yourself back with money you have already paid taxes on.

401K - retirement savings and investing plan that employers offer, text concept button on keyboard

So, you’re now putting after-tax money into a pre-tax account. Then, when you go to take out all of the money in your 401(k), you’re now paying taxes on it all over again. That means you’re paying taxes twice on after-tax money you’re repaying back with interest.

Now, let’s say you lose your job before the money plus interest is paid back. You still have to pay back whatever the remaining balance is on that loan. And if you don’t have the money to pay it back, it will be taxed to you as ordinary income. That’s in addition to the 10% penalty if you were under the typical retirement age of 59 1/2.

In short, leave your retirement alone. Do not take a loan out against it.

Here’s What Other Experts Say About It

“Before you consider taking a loan or a withdrawal from your 401(k), which may be your only retirement savings, make sure you’ve explored other options that could meet your needs,” says Kai Walker, managing director, of Retirement Research and Inclusion Transformation at Bank of America, as quoted by Merrill Lynch.

Instead, if you need money, you can always take out a home equity loan or even a personal loan. But before you even do that, consult with your financial advisor first. The last thing you want to do is screw up your finances with a loan.

In addition, “It is common to assume that a 401(k) loan is effectively cost-free since the interest is paid back into the participant’s own 401(k) account,” says James B. Twining, CFP®, CEO and founder of Financial Plan Inc., as quoted by Investopedia.com. However, Twining points out that “there is an ‘opportunity’ cost, equal to the lost growth on the borrowed funds. If a 401(k) account has a total return of 8% for a year in which funds have been borrowed, the cost on that loan is effectively 8%. [That’s] an expensive loan.”

And, as noted by Securian, “When you reduce the balance of your 401(k) account, you have less money growing along with potential gains in the market. In addition, some 401(k) plans have terms that prevent you from being able to make further contributions until the loan is repaid. So not only are you missing out on potential gains on the amount you withdrew, you may also be slowing down the growth of your principal for the duration of your loan.”

In short, don’t do it unless you’ve discussed it with your financial advisor.