A 401(k) plan account is a tax-advantaged investment vehicle designed for the long haul. Setting money aside paycheck-by-paycheck, year-after-year, a worker steadily builds retirement savings. Sometimes this is accelerated by employer-supplied matching funds.
However, some retirement savers treat their 401(k) accounts like 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 (or up to 15 years for the purchase of a home) at an interest rate set by the employer (typically the prime rate plus 1%). The principal-and-interest payments made to repay the loan go back into the borrower’s 401(k) account, usually through payroll withholding.
With generous terms like these, it’s easy to see why such loans are popular among workplace retirement-plan participants. According to a study published by the National Bureau for Economic Research (NBER), about one in five active participants in 401(k) plans have a loan in any given month.
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 retirement account, you lose out on the potential for valuable tax-advantaged growth of 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 if you have a loan outstanding. Even if further contributions are allowed, plan participants with a loan typically reduce or stop their contributions, according to Fidelity. The reason is simple: Some of the money they had been using to make contributions now has to go toward repaying their loans, and a reduced contribution rate means diminished retirement preparedness. Also according to Fidelity, it takes borrowers two to five years to return to their previous savings rate after taking out a loan.
- Tax and Penalty Risk
This is potentially even more damaging to your finances: If you leave your job — whether by your choice or your employer’s choice — you have to put the amount you borrowed into an IRA or a new employer’s plan by the time current-year taxes are due. According to the NBER study, 86% 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 age 59½.
- An Ongoing Temptation
Once you borrow against your 401(k), it’s all too easy to make a habit of it. Fidelity has found that people who take one 401(k) loan are more likely to take another.
The best alternative to a 401(k) loan is to reconsider your need for the money in the first place. If the money is 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 use other savings.
Likewise, using a 401(k) loan to pay off current debts is often unwise. Not only does such a strategy carry the downsides previously discussed, it fails to address the underlying problems that led you into debt. Using a budget to free up money for debt repayment almost always proves to be a better long-term solution.
Taking a loan against the cash value of a whole-life insurance policy may be a viable alternative if you have such a policy. Doing so reduces the policy’s death benefit, but you’re 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, since the interest may be tax-deductible. Note, however, under the new tax code that took effect at the start of 2018, only home-equity loans taken for the purpose of home improvement qualify for this tax deduction. Also, keep in mind that borrowing against your home equity may put your home at risk if you can’t make the payments on that loan.
If you’re considering a 401(k) loan for a true emergency, there may be better options as well. For starters, simply 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.
(With a Roth 401(k), the rules on early withdrawals are more complicated. Any withdrawal is considered to be a mixture of both contributions and earnings. You need to determine the percentage that is earnings and pay tax on that amount.)
SMI generally advocates using retirement savings vehicles to, well, save for retirement! The “retirement crisis” many people are facing because of insufficient savings has been well documented.
Having a “hands-off” policy toward your retirement account can help prevent a lack of retirement savings from becoming a crisis in your household.