What You Need To Know About Borrowing From Your 401(k)

By Mark Di Vincenzo. May 7th 2016

When it comes to retirement investing, one of the general rules is that investors should never touch their 401(k) plans, which often make up the bulk of their retirement nest eggs.

But many workers can and do borrow from their 401(k)s. Nearly 20 percent of 401(k) plan participants who are allowed to take out loans against their 401(k) savings actually do according to the Employee Benefit Research Institute. The average loan size is about 16 percent of their assets. Twenty-somethings borrow the most -- an average of 29 percent of their assets – though most plans allow workers to borrow as much as half of what they’ve saved to buy a house or pay medical expenses or college costs.

It is important to note that the vast majority of financial advisers do not recommend that their clients borrow from their 401(k) plans to build a swimming pool or buy a new car, but some say it might make sense to do it to repay a high-interest loan if there are no other available repayment options.

This article will focus on why it is a bad idea to use your 401(k) plan as a piggy bank. It will also examine when doing so will hurt you the least.

Why Borrowing From Your 401(k) Is A Bad Idea

You Are No Longer Saving: If you borrow money from your 401(k) plan, most plans won’t let you make additional contributions until you’ve repaid the loan. Even if your plan allows you to make additional contributions, it is difficult to do when you’re trying to repay the loan. Either way, if you do it, you are defeating the purpose of having a retirement plan.

You Are Losing Money: If you are not making additional contributions, you are missing out on potential growth from investments. Not only that, but you are paying yourself back with after-tax money. If you are in the 25 percent tax bracket, earning $1 only gives you 75 cents toward repaying the loan and that 75 cents will be taxed again when you retire and withdraw the money. The interest rate on the loan may be low, but the tax implications are bad.

Time Will Work Against You: Most 401(k) calculations figure that your money will double over eight years on average. If you borrow from your plan to put a down payment on a house, you’ll lose out on an opportunity to double your money within those eight years. The bottom-line value is never likely to ever reach the total that it would have reached if you didn’t take the loan.

You Could Lose Even More Money: This is true if you can’t repay the loan. If you are under age 59 ½, you will have to pay current income taxes plus a 10-percent early withdrawal penalty. (For more information on when you can borrow from your 401(k) without paying the early withdrawal penalty, see When You Can Withdraw Funds From An IRA Or 401(k) Without A Penalty?)

You Are Stuck: Most plans won’t let you quit your job if you have an outstanding 401(k) loan balance. So you are stuck and may have to turn down a great opportunity to land a better job -- with a higher salary -- unless you can repay the loan immediately or you are willing to pay the taxes and the penalty, which further hinders your growth opportunities.

You Shrink Your Nest Egg: If you borrow from your 401(k) for frivolous reasons, you may not be able to borrow more if you have a real emergency.

You Are Living Beyond Your Means: If you need to borrow from your 401(k), it may mean that you are living beyond your means. It may mean that you need to re-examine your budget and your spending habits. And it may mean that you are financially out of control and need help.

Why You Might Want To Do It Anyway

You Have No Other Choice: If you have an urgent need for the money and you don’t have a rainy-day fund or any other pot of money to use, you might consider a 401(k) loan. The same goes if you can’t borrow from a friend or family member and you can’t get a home equity line of credit.

You Need Money For An Excellent Investment: You have a chance to buy a house at much less than market value. You need money for tuition, which will lead to a degree or to certification, which will lead to a much better paying job. You need money to invest in a business or in a financial product that has excellent potential.

It’s The Lowest Cost Loan Available: If you have credit card debt with a very high interest rate and you can borrow relatively cheaply from your 401(k) plan, it might make sense to borrow from your 401(k) to repay your credit card debt. The interest rate from your 401(k) plan may save you money in the long run. Or maybe you must borrow money, but your credit score is low, and money from your 401(k) is much cheaper.

You Have Very Secure Employment: If you might borrow from your 401(k), it helps if you have a stable job and you are very well liked at the company where you work. You can’t take the chance that you might be laid off or fired while you still owe money because you will have to repay the 401(k) loan immediately or pay taxes and a 10-percent penalty on the loan.

You Are Paying Yourself Back With Interest: If you borrow money from your 401(k), you repay the loan with interest. That beats paying interest to a bank or some other lender.

As you can see, there is a lot to think about when deciding whether to borrow from your 401(k). Don’t do it unless you absolutely must borrow the money and you have no other source of income. Look at your budget and your finances. Consider the consequences and determine whether they are too severe or manageable. If you have a financial adviser, get his or her advice. Maybe he or she can come up with a better option.

Sources

More in category

Related Content