Borrowing for the Emergency Fund

Lashawn is considering taking out a 401(k) loan to buy a new car and placing the rest in a savings account for her emergency fund. What does Dave think about that?

QUESTION: Lashawn in Orlando is considering taking out a 401(k) loan to buy a new car and placing the rest in a savings account for her emergency fund. What does Dave think about that?

ANSWER: A 401(k) loan is a really bad idea and here is why. First, you are paying yourself back 3% or 4%, but you are missing out on what the investment would have been making during that time. Whatever amount of money you have borrowed here is not plugged into a good mutual fund that would have been 13% or 14% last year and a bunch so far this year. You miss out on those investment returns.

The second thing is that when you leave your company, and you will leave when you get a better job or get laid off or when you die, your 401(k) loan is due in full at the time you leave. If you don’t pay it in full at the time you leave, the IRS considers that an early withdrawal. They will punch you in the face with a 10% penalty plus your tax rate. You are going to be hit for about 40% of what you borrowed, making you wish you’d never done this.

I would highly recommend you never borrow on a 401(k) for those reasons. Save up and pay cash for your car.

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