Many 401(k) plans allow participants to borrow money from their accounts. It may be a convenient way to get access to cash, but it comes with a price. Read on for the pros and cons that should be considered.
According to a survey by TIAA-CREF, a major retirement plan custodian, twenty nine percent of Americans who participate in a retirement plan have taken a loan from their savings. Yet almost half (44%) of those who borrowed regret making the decision. Paying for an emergency expense and paying monthly bills following a job loss are in the two top reasons cited for the need. Other reasons include paying down debt, home renovations, and special events like a vacation or wedding.
401(k) Loan Provision
Employer retirement plans, such as 401(k)s and 403(b)s, can include a provision to allow participants to borrow a portion of their fund balance. It is important to note that not all employer plans have adopted the loan option due to the administrative cost and burden.
If available, participants can generally borrow up to 50% of their vested retirement plan balance, but must begin immediately to repay the loan via payroll deduction. The principal payment plus the loan interest is returned to the participant’s 401(k) account at a rate that ensures the full amount of the loan is paid back within five years. A longer loan period may be available if the funds are used to purchase a house.
Good Idea
Borrowing from your 401(k) as an additional resource if you face a true financial crisis is not necessarily a bad decision. The 401(k) loan has a lower interest rate than most bank loans, credit cards, and pay day loans. The borrowing cost is usually one to two points above the prime interest rate (currently 3.25 percent). There is no credit check required to secure the loan, no long application, and often few restrictions on what the funds can be used for.
Bad Idea
Even though borrowing from your 401(k) can be simple and fast, the long-term ramifications may it a bad idea. Consider the following:
- Reduced or Eliminated Retirement Savings. If you are paying back a 401(k) loan you will likely reduce or stop making contributions. Less contributions also means lost earnings on those funds. You may also be missing a matching contribution from your employer.
- Missed Investment Return. The money that you borrow from your retirement plan is taken out of your investment pool. While you are required to pay loan interest back to your account, the rate is low and fixed. If the borrowed funds were taken from an equity investment, it is likely that the long-term return of that investment is greater than the interest being paid back with the loan. In addition, the interest is being paid back to your retirement account from your personal cash flow and not the investment markets.
- Less Tax Benefits. You lose the key benefit of tax-deferral on the borrowed amount. When contributions are made to your retirement plan on a pre-tax basis, you are not required to pay tax on the contributions or the investment earnings until those funds are withdrawn during retirement. The loan repayments are made with after-tax dollars. This means you are taking pre-tax money out and then repaying with after-tax money. An added disadvantage, the loan interest paid is never deductible on your income taxes, regardless of the purpose for the loan.
- Immediate Repayment at Termination. If you leave your employer for any reasons, i.e. new job, downsizing, or retirement, your loan must be repaid in full, generally, within 60 days. If you default (more than 80% of workers who leave their job with a loan do) the loan becomes a non-qualified distribution. The outstanding loan amount is taxed as income to you with an additional 10 percent penalty if you are under age 59 ½.
Summary
Borrowing from your 401(k) may provide the needed financial resource to get you through a tough spot. However, it should be done only after careful thought and consideration. Be sure your current short-term need is worth jeopardizing your future long-term financial security.
This article was contributed by Ryan Jeffries, CFP©, a Financial Planning Coordinator at Bedel Financial Consulting, Inc.