If you need a loan, we know an easy place to get one. The lender is sympathetic, doesn’t care about your credit history and would never turn you over to a collection agency.
It’s you, at least as long as you have a 401(k).
The name comes from the section of the tax code that governs them. It sounds suffocatingly bureaucratic, but the employer-run savings accounts are a retirement oasis for millions of Americans who contribute monthly to their financial future.
That brings up the downside of taking money out of your 401(k). It’s supposed to a retirement fund, not a loan office.
Raiding your nest egg could mean a lot less for retirement essentials like food, golf and fishing. Here’s what you need to know before you start trifling with your golden years.
Employees are allowed to borrow up to 50% of their vested savings, up to $50,000.
The loans typically have a low interest rates similar to a 30-year mortgage and are repaid by monthly deductions from your paycheck. Details vary, so contact your company’s Human Resources Department and ask for a copy of the Summary Plan Description.
Loans are typically paid back over a 5 year repayment schedule. If you borrow the maximum amount of $50,000, you’ll likely see around $450 of your biweekly paycheck going to a loan repayment. That’s $900 a month out of your paycheck. Before setting up a large loan, make sure you can afford the payments.
There’s far less muss and fuss than applying for a bank loan or even a credit card since it’s ultimately your decision whether to okay the loan. And unlike other loans, the interest you pay goes back into your account, not to the bank.
But you want to take a 401(k) loan for the right reason. Buying that 65-inch Ultra 4D TV is not a good reason.
In fact, there aren’t many times when tapping into your 401(k) makes more sense than other options, like a debt management plan.
One instance is to pay off a high-interest credit card debt, as a kind of do-it-yourself debt consolidation loan.
Say you have $10,000 on a card that has a 17% interest rate. You’re paying $170 a month for the joy of having that money. If you borrow $10,000 from your 401(k) at 5%, your interest payment drops to $50 a month. So you can pay off your credit card, improve your credit score and save $120 a month in the process.
Another instance where a 401(k) loan makes sense is if you’re buying a house or business and have secured most of the financing, but you need a final infusion of cash to close the deal. As long as you can repay the 401(k) promptly, it’s a viable option.
The key word there is “promptly” because every day that money isn’t in your 401(k) is a day that is costing you money. The savings you contribute every payday is not taxed until you cash in, and the earliest you can do that without big penalties is age 59½.
The whole idea is to leave that pile of cash alone because it’s invested in mutual funds. A 6% annual return is typical, though the stock market has exceeded that in recent years. The Standard & Poor’s 500 Index was up more than 200% from the market lows of 2009 through the end of 2014.
Simply put, if the money’s not in the account, it can’t be making money for you.
Say you take out a $25,000 loan for five years. If a rate of return were 8%, it would have grown to $35,000 had it all been left in your 401(k).
Then there’s the consequences that come if you can’t pay back the loan, it will be taxed as a 401(k) early distribution or withdrawal. If you lose your job, you’ll have only 60 days repay the balance of your loan or pay at your income tax rate plus an additional ten percent penalty.
If you don’t, that “loan” becomes a “distribution” in the loving eyes of the IRS. That means it is subject to income taxes and a 10% early-withdrawal penalty. Taking a full distribution and canceling your 401(k) can cost you hundreds of thousands of dollars in lost growth.
So let’s recap the pros and cons of a 401(k) loan. They offer low interest rates, easy access, contributions are not taxed and the interest goes back into your account. The funds are also protected in bankruptcy proceedings.
On the downside, you could forfeit substantial investment gains and there are sobering penalties if you default. It’s also a red flag warning of more trouble ahead.
A Fidelity study of 401(k) loans taken from 2007-2013 showed that 24% of borrowers decreased their savings contributions in the first year, which is not surprising. But within five years, 40% of borrowers had reduced their savings rate from pre-loan levels, and 15% had stopped saving altogether.
The study revealed half the borrowers took out additional 401(k) loans. Serial borrowing indicates the loans are really just Band-Aids for people who don’t know how to manage their debt.
The Fidelity study showed that nearly 40% of retirees who had taken 410(k) loans said they wouldn’t do it again. They realized, often too late, that there were better ways to cure what ailed them.
The most effective is often a debt management program from an accredited nonprofit debt management organization like InCharge. Credit counselors review your finances and devise a strategy to address the issues.
One way is a debt consolidation plan, where you stop using credit cards and the counselor negotiates lower interest rates from your creditors. The reduced debts are lumped together and you make only one monthly payment to the nonprofit, which distributes the funds to creditors.
Most debt consolidation programs last about three years. Clients learn to change their spending habits and live within their means, so they won’t have to use options like a 401(k) loan.
It’s not always a bad option. Just remember whose pocket the money is coming out of. That’s the last person you want to see throw their retirement away.
(Ashford, K.)(2016, May 31). 7 Questions To Ask Before Borrowing From Your 401(K). Retrieved from http://www.forbes.com/sites/kateashford/2016/05/31/401k-loan/#3c64c0d88ca6
(NA)(ND). Distribution Options. Retrieved from https://www.smart401k.com/resource-center/retirement-strategy/401k-distribution-options
(NA)(2017, July 23). Five reasons to be cautious about 401(k) loans. Retrieved from https://www.fidelity.com/viewpoints/retirement/be-cautious-about-401k-loans