Borrowing Against Your 401k – Is It Ever a Good Idea?
One of the many perks available to working folk is a company-matched 401k retirement plan, named after the part of the tax code authorizing it. One feature many people don’t realize is that the account holder can borrow against the balance of the account. About 87% of funds offer this feature. The account holder can borrow up to 50% of the balance or $50,000, whichever is lower, but the whole amount must be repaid within 5 years. There’s no approval process and there’s no interest. It’s basically a loan you give yourself and is a popular enough option that 17% of millennial workers, 13% of Gen Xers, and 10% of baby boomers have made loans against their 401k accounts.
Despite these benefits, borrowing against your 401k is a risky proposition. There are harsh penalties for failure to repay and taking money away from retirement savings is always risky. Borrowing against your 401k account should not be a decision that is made lightly.
As with most financial moves, there are benefits and disadvantages to borrowing against your 401k. It can be difficult to sort through them, particularly if your need for money is acute and immediate. Before you borrow from a 401k, though, ask yourself these four questions:
1.) Will borrowing against your 401k fix the problem?
Many borrowers use money from their 401k to pay off credit cards, car loans, and other high-interest consumer loans. On paper, this is a good decision. The 401k loan has no interest, while the consumer loan has a relatively high one. Paying them off with a lump sum saves interest and financing charges.
But the question of whether repaying that loan will fix the underlying problem remains. Take a look at your last six months of purchases. If you had made a 401k loan six months ago and paid off revolving debt, would your debt load still be a problem? Perhaps not – your current situation may reflect an emergency or an unplanned expense. On the other hand, if your credit cards are financing a lifestyle that is above your means, you may find yourself back in the same position a year down the road – and with no money in your 401k.
Borrowing against a 401k to deal with a medical bill, a first-time home purchase or an emergency car repair can be a smart move. Using a 401k loan to put off a serious change in spending habits is, as one financial expert put it, “like cutting off your arm to lose weight.” Before you borrow against your future, make sure it will really fix your present.
2.) Will the investment offer a better return?
Your 401k is earning money for you. It’s invested in stocks, bonds, and mutual funds that are appreciating, usually at a fairly conservative pace. If you pull money out in the form of a 401k loan, that stops.
The statement that a 401k loan is interest-free is only technically true. You have to pay back what you pull out, but before you do, it doesn’t earn any interest. Therefore, the “interest” you pay on your 401k loan really comes in the form of the gains you never produced on the money you borrowed since you were not investing it during that time.
If you’re borrowing from your 401k to invest in a business, ask yourself if your new venture will be at the return you’re currently getting. If you’re planning to pay off your mortgage, compare the interest rate you’re paying to that return. Don’t worry about trying to time or forecast the market. Assuming a 4% return (a safe average) is the most prudent course of action.
3.) Is your job secure?
If you’ve recently been promoted or gotten new training on an important job duty, you can be pretty confident you aren’t going to be let go from your job any time soon. If your recent performance reviews haven’t been stellar, or if your company has some layoffs pending, you might want to beware. Hold off on borrowing from a 401k if you’re at all hesitant about your future at the company.
If you lose your job or retire with a loan outstanding, you have 60 days to repay the loan in its entirety. Otherwise, it counts as a “disbursement.” You’re responsible for taxes on the entire amount and you’ll have to pay a 10% early withdrawal penalty. Staring down big bills like that after you’ve just lost your job is not a fun predicament.
While job loss can happen at any time, you want to make sure you’ll be happy and welcome at your current employer for the next five years before you pull money out of your 401k. You may also want to consider accelerating your repayment plan to get your 401k refunded as quickly as you can. Unlike some loans, there’s no penalty for early repayment. Plus, the sooner the money is back in your account, the sooner it can start earning for you again.
4.) Do you have options other than borrowing against your 401k?
If you’ve identified your need for money as immediate, consider what other options you may have available before you dig into your retirement savings. For home repairs, using a home equity loan can be a smarter choice. For an outstanding car loan, refinancing may make more sense. It may be wiser to negotiate a repayment plan with the hospital for a medical bill.
If you’re purchasing a first home, consider the tax implications of mortgage interest. In many cases, you’ll receive preferential tax treatment for interest paid on a home loan. You won’t receive that same benefit from a 401k loan.
Borrowing from a 401k can be a good way to solve a short-term, specific problem. It does have risks, however, and the consequences to your future can be severe. If you’ve got another option, that’ll be a better option for you more often than not.
If you like what you read, then join our e-mail list!
Sources:
http://www.investopedia.com/articles/retirement/08/borrow-from-401k-loan.asp
https://www.bankrate.com/loans/4-reasons-to-take-out-a-401k-loan/