Here's What Happens When You Don't Repay a 401(k) Loan

There may come a point when you need to borrow money, whether to repair your car, fix something in your home, pay a medical bill, or cope with a brief period of unemployment. Applying for a loan can be a hassle, and so if you have money in a 401(k) plan already, you may be inclined to borrow against it. After all, that money is yours, and many 401(k) plans do allow savers to take out loans against their balances. (Note that IRAs do not offer the same option.)

But taking out a 401(k) loan is a very risky move. And it's one you may be better off avoiding under most circumstances.

Not repaying a 401(k) loan is a big deal

If you take out a short-term 401(k) loan and pay all of that money back, then it may not hurt you too much in the long run. It's when you don't repay a 401(k) loan that big problems can arise. 

For one thing, if you don't repay a 401(k) loan, it will be treated as a distribution from your retirement plan. If you're not yet 59 ½ at the time of that distribution, you'll be subject to a 10% early withdrawal penalty on the sum you remove. 

But that's not even the worst part about failing to repay a 401(k) loan. Not only will you lose money to an early withdrawal penalty, depending on your age, but you'll deny yourself years of gains in your 401(k).

Let's say you invest your 401(k) plan primarily in stocks. Over the past 50 years, the stock market has generated an average yearly return of 10% before inflation, as measured by the S&P 500 index.

Meanwhile, let's say you take out a 401(k) loan in the amount of $15,000 and don't repay it, at which point it becomes a distribution at age 40. If you don't retire until age 65, it means you're losing out on 25 years of gains on that $15,000. And if your 401(k) delivers an average yearly return of 10%, that $15,000 early withdrawal could end up costing you a whopping $162,500 in retirement income. Not to mention, there's still the loss you would have taken from the early withdrawal penalty -- 10% of $15,000 is $1,500, and that's no small loss either. 

Find a different way to borrow

It can be fairly easy to qualify for a 401(k) loan because the money is there, and it's yours. But a better bet may be to apply for an outside loan when you have to borrow money so you don't risk ending up short on retirement income.

One option you can look at is a personal loan, and you might snag a nice, competitive interest rate on one if your credit score is in great shape. Another option is to take out a home equity loan. This, too, might result in a fairly reasonable interest rate on the sum you borrow, since your lender is protected by the fact that your home itself serves as collateral for that loan.

Some people take out 401(k) loans and repay them in a timely manner and it all works out just fine. But do you really want to take that chance? If you'd rather not run the risk, find an alternative means of borrowing money so you don't wind up many thousands of dollars shy by the time retirement rolls around.