The majority of 401(k) providers offer a loan provision that allows participants to loan themselves money from their 401(k)’s at a relatively low interest rate. We often get questions about whether it’s a good idea to loan yourself money from your 401(k). While it can seem attractive on the surface due to low interest rates in addition to the fact you’re paying yourself back (interest is paid to your 401(k) account), not a bank or institution, there are several other considerations to take into account that people often overlook. This article will answer common 401(k) loan questions, risks to be aware of, when a loan makes sense, and more!
How do 401(k) loans work?
If you’ve contributed to a 401(k) over the years or are just beginning to make contributions, you’ll likely have access to your employer’s plan and loan provision. Most 401(k) loan provisions allow you to withdrawal $50,000 or half the vested value of your account, whichever is less. For example, if your 401(k) account balance is $30,000 and only $20,000 is vested, you’d have the option of taking out a $10,000 loan or half the vested balance.
Typically, the loan balance must be paid back within 5 years of taking out the loan. If it’s not paid back within that time period you’ll subject the remaining balance to the early withdrawal penalty of 10%! Not to mention, in the case of traditional 401(k)’s which are pre-tax contributions, you’ll be paying income tax on the outstanding loan balance. It’s important to have a plan in place should you take a 401(k) loan in regards to how you’re going to pay off the balance to make sure you don’t get hit with a huge tax whammy.
Lastly, unlike a bank loan, with a 401(k) loan you’re paying yourself back. The interest and principal payments towards the loan go back into your account. Yes, this might sound too good to be true, but as I’ll explain later, there are other risks to consider.
How are interest rates determined?
Your employer and plan provider determine the interest rate associated with the 401(k) loan. Therefore, every plan is different.
What happens if I leave my employer while I still have a 401(k) loan balance?
If you’re terminated, leave, or for whatever reason are no longer employed where your 401(k) loan balance remains, you’ll have 90 days to pay off the loan. If you’re unable to do so, the loan balance will be treated as a distribution, subjecting you to an early withdrawal penalty and potential income tax (traditional 401(k)).
When considering whether to take out a 401(k) loan it’s important to keep in mind you’re “tying” yourself to your employer for up to 5 years or until you can pay off the loan, or face major tax consequences.
What’re the major risks associated with taking a 401(k) loan?
Obviously, the first risk most people are aware of is being unable to pay back the loan. If you default on paying back your 401(k) loan you’ll be subjected to a tax whammy as described above. Having a plan in place prior to taking out the loan with how you’ll manage your cash flow to pay off the loan balance is paramount.
The risk most people aren’t aware of when it comes to taking a 401(k) loan is the opportunity cost of tax-deferred (traditional 401(k)) or tax-free (Roth 401(k)) growth. The current bull market has been a great example. If someone had taken a $50,000 loan for the last 5 years, they’ve missed out on exceptional growth in the stock market in a tax-advantaged account! Tax-advantaged accounts such as the 401(k) essentially “grow” faster than a nontax-advantaged account. Because taxes are deferred or tax-free, they result in greater compounding over time.
More specifically, in 2017, the S&P 500 returned roughly 20%. An investor who had taken a $50,000 loan, potentially missed out on $10,000 in returns! Not to mention, we’re limited to how much we can contribute to these tax-advantaged accounts, and as a result, can never get back years where we don’t contribute or in this case, remove funds from the account. Funds that are contributed to a retirement account such as a 401(k) in most cases are better left there for their original purpose, as long-term investments.
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When do 401(k) loans make sense?
You may be tempted by the low-interest rates, easy access, and the fact you’re paying yourself back, but there are limited situations in which it actually makes sense to use a 401(k) loan. The risk of missing out on tax-deferred or tax-free growth is too great. The situations in which it may make sense are typically associated with paying off higher interest rate debts. However, it’s important to address the reasons and behaviors that accumulated that debt in the first place. Typically, double-digit interest rate debts are associated with credit cards or some form of consumer debt. Establishing a budget, or using a personal expense worksheet to get a better understanding of your monthly cash flow can help you curb your use of credit cards an eliminate unnecessary spending.
401(k) loans should not be used to finance vacations, a new car, or any other type of leisure expense, and unless it’s a last resort, should typically only be dipped into for paying off higher interest rate debts.
Should I use a 401(k) loan to help finance a home purchase?
No. Next question.
Just kidding, but in all honesty, you’re better off using a mortgage to finance your home purchase. If you’re having to consider your 401(k) as an option, you’re likely buying out of your price range and should consider giving yourself more time until you buy, or looking for a cheaper place. Not to mention, using a mortgage will in most cases, allow you to itemize your deductions and reduce your tax liability. Where a 401(k) loan does nothing to benefit you tax-wise, it just delays your ability to grow retirement assets.
For more on deciding when to buy a home read: Renting vs Owning a Home: The Pros and Cons of Each.
As you can probably determine after reading this article, in most cases, it simply doesn’t make sense to take a loan from your 401(k). You’re borrowing from your future, which you’ve already agreed to set aside the funds to invest for!
If you have more 401(k) loan questions, I’d be happy to address them. Schedule a free consultation or email me directly at firstname.lastname@example.org