Does a 401(k) Loan Make Sense for You?
The Pros and Cons of Taking Out a Loan From Your 401(k)
In general, the state of retirement preparedness remains low throughout the country. The Center for Retirement Research at Boston College found that 52 percent of people preparing for retirement were at risk to not be able to meet their lifestyle goals. That’s why the mantra for anyone who wants to see a hint of financial independence later in life is usually “save, save, save”!
But what happens when you feel the urge to access some of your retirement savings through a 401(k) loan?
If you are trying to balance the need to pay your current bills with the desire to save for the future, it may feel like prioritizing saving versus paying off debt is a significant challenge. Your vested 401(k) balance is your money, and it can seem quite tempting to access your retirement savings through a 401(k) loan to pay down debts, purchase a home, or pay for “life happens” moments. According to the Employee Benefit Research Institute (EBRI) 20 percent of all retirement plan participants who were eligible for 401(k) loans had outstanding loans against their 401(k) plan accounts at the end of 2014.
While 401(k) loans may seem like a convenient option to turn to if other alternatives don’t exist, you should only use one as a last resort. If your retirement plan provides for loans, the maximum amount the IRS allows you to borrow is 50% of your vested account balance, or $50,000, whichever is less. The decision to take out a 401(k) loan may have a significant effect on your future retirement nest egg. So it’s important to realize the advantages and disadvantages associated with a 401(k) loan.
Here are some of the advantages for you to consider:
You do not need a credit check. 401(k) loans are taken out based on your available vested account balance. You do not have to rely on your credit history to be eligible. This makes it relatively easy for you to access your money without concerns about being denied a loan due to bad credit or limited credit history.
Your interest rates are generally lower than what you will find with other personal loans and most credit cards. Most 401(k) loans have relatively low-interest rates and they are often linked to the Wall Street Journal prime rate (3.5% as of July 2016). When you put this low-interest rate side-by-side with the average credit card interest rate of around 15% you have the potential to see significantly lower costs of borrowing. Another benefit is that you are paying interest to yourself and those payments go back into your own account.
Your loan proceeds are not subject to income taxes (unless you don’t pay back the loan). You will not have to pay any additional income taxes for taking out a 401(k) loan. This is because 401(k) loans are not considered a taxable withdrawal. This is usually a much better alternative to taking a hardship withdrawal from a 401(k). Hardship withdrawals are taxed at your ordinary income tax rates and with a few exceptions are also accompanied by an additional 10% penalty if you’re under age 59 ½.
Here are some of the disadvantages of a 401(k) loan to consider:
There is a potential risk that future earnings growth on investments will be lost. 401(k) loans have the hidden downside of opportunity cost. That's why you should always think about the long-term effects of a 401(k) loan decision. Many 401(k) loans have a 5-year term while some have loan repayment terms that range up to 10-15 years. The investment potential in U.S. equities has historically been positive over rolling five year periods. For example, according to this tool from Betterment the S&P 500 has positive gains 87.4% of the time over 5 year time periods from 1928 to 2014 (hint: that’s 21,502 potential holding periods).
You should always realize that it’s never a good idea to look into the rear view mirror when it comes to important financial decisions. Also, keep in mind that the opportunity cost of lost investment gains is somewhat less of a concern when your loan amount is not a sizable portion of your overall investment portfolio or if you’re a conservative investor.
Your 401(k) loan payments are deducted directly out of your paycheck as an after-tax deduction. The automated process of making 401(k) loan payments through payroll deduction is often viewed as an appealing feature. However, extra loans will have an impact on your take-home pay and need to be incorporated into your revised budget. Sometimes these extra payments force people to reduce their contributions to the 401(k) plan and this can result in missing out on an employer match and lower retirement plan balances over time.
Changes to your payroll deductions should always prompt a basic review your personal spending plan to make sure you are prepared for the change in pay ahead of time. You don’t want the loan payments to make it hard for you to pay your everyday living expenses or other debt obligations such as a mortgage or vehicle loan.
Your 401(k) loan could become a future tax headache. You could end up owing taxes and penalties if you leave your employer and default on the loan. This is perhaps the most significant risk of taking a 401(k) plan loan. Use caution if there is any chance you will still owe money when you leave your job. In most cases, any outstanding loan balance that you don’t pay back within 60 days is considered a withdrawal and subject to taxes and possibly a 10% penalty if you’re under age 59 1/2.
Some employers do not require you to payoff a 401(k) loan within the 60 day window if you’re laid off or leave before the loan is repaid. So be sure to check with your HR department if you aren’t sure about the rules of your plan. Even if a 401(k) loan payoff plan is available after you leave your job you will still have to stay current with loan payments to avoid a taxable distribution. When you lose the ease of payroll deduction for loan payments staying current isn’t as easy.
If you are unable to avoid the temptation to carry a balance on your credit card use you may end up with more debt. Most financial planners warn people about the potential dangers of 401(k) loans when they are being used as a quick fix for bigger money management or debt problems. I’ve witnessed way too often the struggles people endure when their credit card and consumer debt issues become compounded by income tax problems as a result of defaulting on a 401(k) loan. I’ve also witnessed people create an effective plan to use their retirement plan loans to consolidate debt lose focus and end up with more debt than when they started due to credit card balances and other debt issues.
Is a 401(k) loan a good idea for you?
The bottom line is you will likely need to rely heavily on your own personal savings to reach a state of financial independence during retirement. In most cases you should avoid the urge to dip into your retirement savings due to all of the hidden downsides of a 401(k) loan. That being said, there are some strategic ways to include a 401(k) loan into your financial life plan. Whichever option you decide, consider the pros and cons very carefully and make a calculated decision that will not put your future retirement plans in jeopardy.