How To Borrow From Your 401(k)
At first glance, borrowing from your 401(k) can seem like the biggest no-brainer this side of Uber McDonalds. It’s a pot of money. It’s yours. You can take a loan against it with no credit check, next to no fees, and interest rates Warren Buffett would envy.
Wait. There’s more. Generally, you pay it back through payroll deductions, so it’s conceivable you could grab that loan and barely notice a difference in your take-home pay.
So far, so great, right? After all, if your employer (and the friendly folks at the IRS) hadn’t wanted you to borrow against your 401(k), they wouldn’t have made it possible. Indeed, a small minority of employers’ plans prohibit loans, but if yours is among the roughly 87% who allow them, it’s sort of like an invitation.
Stop right there. In the sections below, we lay out just what a 401(k) loan entails and why, tempting though it might be, there are good and varied reasons not to take that easy road.
Pros & Cons
We’ve touched on some of the pros. Let’s lay them out in their entirety.
- There’s no credit check. This is great news for borrowers with dings in their credit history. Moreover, the process happens without notification to any credit reporting agencies, so there will be no impact on your FICO score.
- The interest rates tend to run only a point or two above the prime rate.
- You’re borrowing from yourself, so the interest charges are invested in your account. If your 401(k) was invested in stock mutual funds and you’re repaying your loan during a Wall Street slump (a mighty big “if”), you could wind up ahead of where you otherwise would have been.
- The application process is uncomplicated.
- Access to the cash is swift, often within only a few days.
- Repayment usually relies on payroll deductions, alleviating the borrower of any active responsibility for repayment beyond keeping his job with the employer who oversees the 401(k) plan.
- If you prefer and have the ability, you can repay the loan faster with no prepayment penalty worries.
- Potential cost advantage. Let’s say the interest on a comparable consumer loan is 8%, and the lost estimated investment earnings over the course of the loan is 7%. The cost advantage would be 1%, a win for the borrower. Plainly, this is exceedingly speculative, a roll of the dice, but if those numbers held up, it’s advantage borrower.
Now, the reasons to resist easy temptation.
- You immediately reduce the money that otherwise would be growing for your retirement life. Imagine having liquidated $20,000 in a stock fund that tracks the S&P 500 for a loan in October 2016. You’d have missed a 15.6 percent uptick over the course of the next year, or roughly $3,120 gained, which, in turn, would have been available to compound upon itself year after year after year.
- The above example might be extreme — the historic S&P 500 return, after all, is 7.29 percent, less than half the recent run-up. However, catching up even against that traditional return is difficult. As financial planner Ric Edelman, widely praised by Barron’s and Forbes, told CNBC, “Every $10,000 you borrow from your 401(k) will reduce your future wealth in retirement by $100,000.”
- Borrowers incur double taxation. The amount in interest paid into your 401(k) is after-tax dollars, accounting for the first bite. The second bite occurs when you begin withdrawals in retirement and those interest payments are taxed again. Some financial pundits argue the amount is insignificant. Nonetheless, it’s a factor to be considered.
- It is well established that most participants who borrow from their 401(k)s ultimately reduce or even halt their contributions during the payback period. Accordingly, they often sacrifice the advantage of company matching contributions, since they no longer meet the maximum matched percentage.
- Once is oftentimes not enough. A Fidelity study in 2013 revealed that the first 401(k) loan often serves as a gateway to several more bites at the nest egg, compromising otherwise glowing retirement plans.
- Without a viable plan to repay the debt within a couple of months, you could incur staggering IRS distribution penalties if you lose your job.
Alternatives to Borrowing from Your 401(k)
Once you’ve begun to contemplate borrowing from your 401(k), you’re going to read or hear this phrase a lot: “Do it only as a last resort. Exhaust every other alternative.” Who doesn’t love alternatives? So what other choices do you have if you need a lump sum of money quickly?
- Home equity. Interest rates for borrowing against the equity in your house tend to be lower than most other loans, and the interest portion of payments is tax-deductible.
- Personal loan from a bank, credit union, or internet peer-to-peer lender.
- Cash-value life insurance policies.
- Selling other investments or assets.
- Drawing down other liquid assets, such as savings accounts or CDs.
- Family members.
- Taking on a second, part-time job.
What You Should Know Before Borrowing
Before you take the plunge, consider, also:
- Generally, you can borrow no more than $50,000 against your 401(k), or one-half of your plan balance, whichever is less.
- Repayments begin almost immediately, typically with the next pay period. Make certain you can withstand the impact on your budget.
- Compare interest rates against other loans available to you. Factor in such things as the deductibility of interest on refinanced mortgages or home-equity loans.
- Restrictions apply. Borrowing to acquire a first house buys you leniency, but otherwise loans must be repaid in five years or fewer.
- If your choices are either a loan against your 401(k) or an outright distribution, and you are younger than 59 1/2, the loan is almost certainly preferable. After all, a distribution in your 30s or 40s incurs a 10% penalty as well as a bump in your taxable earnings; a loan — assuming it is paid off while you are still employed with the plan’s overseer — avoids all of that.
When to Borrow from Your 401(k)
The shortest, possibly best, answer is: almost never.
A 401(k) plan is your post-work-life nest egg, after all. Funded aggressively and consistently, rebalanced annually and astutely monitored — but otherwise left alone — a 401(k) could be the difference in golden years spent touring historic ruins, or retirement plans left in ruins.
Still, our financial lives usually are nothing if not complicated, and the above advice, however worthy, could fail in the face of certain events or opportunities. Retirement experts and the IRS alike have attempted to anticipate when it might be appropriate to borrow on your 401(k) — the IRS with rules governing loans, retirement experts by performing balancing acts that rival Cirque du Soleil acrobats.
Both begin by warning against borrowing from your 401(k) as anything except as a last resort. The IRS amplifies the warning with awful penalties if payback plans go south. Financial planners simply lay out those consequences and worse
As Edelman told CNBC, “It’s not a loan; it’s a withdrawal, and it’s a really bad idea. Using the money should be your very last resort.” And here he applies the hammer: “If you still have a television set or jewelry, you haven’t exhausted all your options.”
As a reminder, we laid out the alternatives above. So, assuming all other avenues are closed, here’s when it makes the best sense to borrow from your 401(k):
- Buying your first house
- Expenses that follow the onset of a sudden disability
- Higher-education expenses, such as college for your youngsters, or an advanced degree for yourself that will enhance your earning potential (after making sure your employer doesn’t have a tuition-reimbursement program)
- Financing a business (although financial advisors differ on whether this is a great idea)
- Paying off certain types of debt (but only under narrow circumstances, and, again, not widely recommended)
- When you absolutely, positively must have cash to repair a desperate short-term liquidity problem (but only — only! — if you can repay the loan in a year or less)
- Assuming the provision immediately above is true, borrow from your 401(k) only if it is the lowest-cost loan option available
Again, have a plan to repay the loan if you sour on your job, your boss sours on you, or your industry is souring to the point of potential layoffs. Even given ideal reasons to borrow, you could suffer an enormous financial setback if your job goes south and you lack a viable course of action to pay off the loan, which could turn into a costly gargoyle of a distribution in 60 days.
Just to Recap, with a Word About IRAs
In the world of retirement planning, 401(k)s and traditional IRAs share many traits and virtues, such as tax-advantaged savings and investment earnings. One important way in which they differ, however, is in the realm of borrowing. In short, you cannot borrow against an IRA.
Tap an IRA, and, except for a few extreme hardship situations, you have taken an irrevocable distribution, with daunting tax consequences and penalties. Worse, because, by statute, IRA contributions are limited to $5,500 annually, the gouge created by a working-life distribution is unlikely ever to be recouped.
If you want to borrow against a retirement fund, then, the 401(k) is the only game in town … even if it’s a game with lots of downside.
With so much to recommend against them, you have to figure there must be a reason 401(k) plans contain loan codicils. And you would be right. Maybe. Possibly not. It once was widely believed 401(k) participation went up (a good thing) if employees knew their funds weren’t locked up beyond all recourse. Sentiment has lately swung slightly in the other direction.
Most likely, being able to take out a loan against your 401(k) is a necessary evil, like spray cheese or Justin Bieber. Once you’ve committed to taking one, embrace the theme song from the Mel Brooks film, “The Twelve Chairs”: Hope for the best, expect the worst.
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