A 401(k) retirement account is an investment vehicle designed for the long haul. Setting money aside paycheck-after-paycheck, year-after-year, a worker steadily builds a retirement nest egg. This often is helped along with employer-supplied matching funds — the easiest money you'll ever make. But some retirement savers have come to see their 401(k) as a piggy bank for short-term wants or immediate needs. While 401(k) loans are easily accessible and the terms seem attractive, there's a price to pay for borrowing against these accounts.
How do 401(k) loans work?
The ability to borrow from your 401(k) balance is determined by your employer. If such loans are allowed, they're available to all participants in the plan — no credit check required. Borrowers usually may take the lesser of 50% of their vested balance, or $50,000. The money needs to be repaid within five years (longer terms are usually available for the purchase of a primary residence) at an interest rate set by the employer (typically the prime rate plus one or two percentage points). The principle and interest payments you make to repay the loan go into your 401(k) account ("You pay yourself back with interest!") and may be made through payroll withholding.
With generous terms like these, it's easy to see why such loans have become popular. Through the first quarter of 2013, between 18% and 25% of plan participants had loans outstanding.
What's wrong with a 401(k) loan?
While 401(k) loans may seem appealing, there are downsides.
- Opportunity costs
By taking money out of your nest egg, you lose out on the potential for very valuable tax-advantaged growth on that money. In essence, you are robbing your future to pay for your present.
In addition, some companies won't allow you to contribute to your plan or won't make matching contributions while you have a loan outstanding. Even if you are allowed to continue making contributions, several studies show that plan participants with a loan contribute, on average, about 2 percentage points less than those without a loan. Some of the money they had been using to make contributions now has to go toward repaying their loans, and a lower contribution rate means less retirement preparedness. A Fidelity survey found that it takes borrowers two to five years to return to their previous savings rate after they take out a loan.
- Tax and penalty risk
This is potentially even more damaging to your finances: If you leave your job — whether by choice or not — you typically have only 60-90 days to repay a loan. According to consulting firm Aon Hewitt, more than two-thirds of people who leave their jobs with a loan outstanding fail to repay. Such defaults trigger tax payments and a 10% penalty for those younger than 59½. Even if you stay in your job, the interest you pay will be taxed twice — once when you repay the loan and once again upon withdrawal in retirement.
- An ongoing temptation
Once you borrow against your 401(k), it's all too easy to make it a habit. Fidelity has found that half of all such borrowers have taken out loans more than once.
Alternatives to a 401(k) loan
The best alternative to a 401(k) loan is to reconsider your need for the money in the first place. If it's for a want such as a kitchen remodel, new car, or vacation, it'll serve your bottom line much better to wait until you can buy with other savings. Likewise, using a 401(k) loan to pay off current debts is usually unwise. Not only does such a strategy carry the downsides previously discussed, it also fails to address any of the underlying problems. Creating and instituting a budget to free up money for debt repayment almost always proves to be a better long-term solution and means of staying out of future debt.
If you're considering a 401(k) loan for a true emergency, there may be better options as well. For starters, suspending new contributions to your account can free up cash flow. If that's not enough, those with a Roth IRA can withdraw their contributions (not earnings) at any time without having to pay taxes or a penalty.
Taking a loan against the cash value of a whole-life insurance policy may be a viable alternative if you have such a policy. Be aware that doing so would reduce the policy's death benefit, but you are required to pay only interest on the loan, and the dividends from the policy may be sufficient to cover those costs. Check with your agent.
A home equity-loan is another alternative to consider since its interest may be tax-deductible (as opposed to double-taxed, as the 401(k) loan's interest will be). However, keep in mind that doing so may put your home at risk if you can't make the payments on that loan.
We generally advocate using retirement savings vehicles to, well, save for retirement. The "retirement crisis" many people are facing due to insufficient savings has been well documented. Having a "hands off" policy toward your retirement account is one relatively simple step you can take to prevent a lack of retirement saving from becoming a crisis for your household.