Should I borrow from my 401k?
In our recent blog, Understanding the Ins and Outs of 401(k) Plans, we touted the great benefits of 401(k) plans. Some investors might also see this as a source of potential funds for personal loans. Your 401(k) is a powerful savings vehicle that is intended to be a nice nest egg to fund your retirement. Taking money out of retirement savings when you are still years from retirement seems contradictory. However, 401(k) loans can be appropriate for some people in certain situations.
So why would I use my 401(k)?
As long as your plan allows for loans, participants can generally borrow for any reason. Essentially you are borrowing from yourself. You will need to evaluate all of your borrowing options and choose the one that makes the most financial sense for your particular need. You may find that your 401(k) can offer loan terms that you cannot find elsewhere.
401(k) loans can be a quick and easy way to get money when you need it. You can often initiate the loan online and receive a check within 10 days. There is no underwriting and since there is no credit check, it won’t affect your credit. If you need cash quickly for a serious short-term liquidity need, a 401(k) loan can be an ideal solution. Alternatively, it could also be used to fund a large investment, such as a down payment on a house or business, or to pay down high interest debt. Again, you will need to explore all of your funding sources, including withdrawing from your IRA, and determine which scenario is the most cost effective.
How much can I borrow?
Plans can set their own borrowing limits, but the IRS establishes a maximum allowable amount. If your plan permits loans, you can borrow $10,000 or 50% of your vested balance, whichever is greater, but not more than $50,000.
What are the terms of the loan?
You have up to five years to repay your 401(k) loan. Per IRS guidance, substantially equal payments, which include both principal and interest, must be paid at least quarterly. Plans typically allow you to repay your loan through payroll deductions. The interest rate is usually determined by the plan administrator and is based on the prime rate. The interest you pay is paid back into your 401(k), so essentially you are paying yourself. You should be aware that the interest you pay yourself is effectively taxed twice. The interest on each payroll loan payment is taxed, then taxed again when it is paid out to you as income in retirement
What are the risks?
Even if you can borrow from your 401(k) penalty-free, it doesn’t necessarily mean you should. Easy access to a 401(k) loan can very quickly make a bad financial situation even worse. According to a study from the Pension Research Council at the Wharton School, University of Pennsylvania , 10% of 401(k) loans are not repaid, with the majority of those being employees who have moved on to a new job. Loan default from retirement plans is approximately $6 billion a year. Any loan balance that is not repaid according to the repayment terms would be considered a taxable distribution.
Potential Taxes. You should never borrow against your 401(k) if you plan to leave your employer in the near future, or if your job status is not secure. The balance of a 401(k) loan is due shortly after you leave your employer. The Tax Cuts and Jobs Act of 2017 did extend the window to repay or rollover an outstanding balance on a 401(k) loan when an employee leaves a job. The deadline is now the due date of your tax return for the year in which the distribution occurs, including extensions. For example, if you left your employer in March of 2019, your loan would be due by April 2020, assuming you do not file any extensions. If you do not repay the loan according to the loan repayment terms, then any outstanding loan balance would be considered a distribution which would be taxed at your income tax rate and assessed a 10% penalty if you are under the age of 59 ½. For example, if you had a loan balance of $10,000 that you were unable to repay and were in the 22% tax bracket, you would pay $2200 in federal tax, plus $1000 in penalties (and this does not factor in state taxes). You would need to make sure that you had enough after-tax cash available to pay the tax and penalty, outside of the funds you have withdrawn from your 401(k).
Ongoing Contributions. Another negative to consider is the fact that some plans don’t allow participants to make contributions while they have an outstanding 401(k) loan. This is something you should find out prior to taking any steps to borrow from your 401(k) plan. If you don’t make contributions, you aren’t eligible for the employer match. You are walking away from free money when you don’t take advantage of your employer match. If your plan has this stipulation, and it takes you five years to pay off the loan, that is five years of employee and employer match contributions you might be forfeiting.
Opportunity Cost. Lastly, and most importantly, you really need to consider the opportunity cost of withdrawing your 401(k) funds. Not only will your plan lose the principal amount of your withdrawal, you will also miss out on potential rates of return higher than the interest rate you are paying yourself. The compounding effect of taking this money out, particularly at a young age, can drastically reduce your chances of being ready to retire on time. For example, if you borrow $25,000 at age 40, and your portfolio averages a 7% annual return, then by age 60, your plan will be short over $95,000.
In summary, it pays to explore your different options before tapping into your 401(k). It can be a convenient and easy solution, possibly even the ideal solution. However, there are definitely some downsides to consider. The more money you take out during your working years, the less money you will have available to you in retirement.