By: Investor Solutions, Inc.
If you’re thinking of tapping into your 401k Plan to pay debts, buy a car, pay for a wedding or go on vacation? Think again! Borrowing from your 401k can have disastrous consequences on your finances. Before you take such a drastic step, here is what you need to know.
The History of 401k Loans
It goes without saying that Americans are not good savers. So, in order to encourage participation in their 401k, plan sponsors are increasingly including loan and withdrawal features. And while knowing they have the ability to access the retirement account may put participating employees at ease, this benefit is really a double-edged sword.
It is estimated that about 90% of 401k plans allow for loans. In plans that permit loans, on average 25% of participants have them, averaging $5,936 per borrower.
If you borrow from your retirement plan, the money is no longer “working for you”. Over the period of the loan, you may be giving up growth in your account in the form of interest, dividends and capital gains. Moreover, you will reduce the benefit of tax-free compounding.
Your opportunity cost grows further if during your repayment period, you decide to stop your regular contributions. Human nature may tempt you to stop your plan contributions, since your disposable income diminishes with your loan payment. But don’t shoot yourself in the foot, stay disciplined and keep on saving.
If your 401k allows for loans, you can borrow up to 50% of your vested account balance or $50,000 (whichever is less). And unless you are borrowing for a first home purchase, which gives you a 30-year payback period, you get five years to pay back the loan.
It’s a whole other story, however, if during the repayment period you terminate employment. Before you leave the employer, your loan must be paid in full.
If you still have an outstanding loan balance and cannot pay it off, the penalties if you are under 59 ½ years old are not pretty. You will pay a 10% penalty for the early withdrawal on top of the ordinary income taxes on the distribution, which is the unpaid balance.
Pro’s and Con’s
Most participants are tempted to borrow from their plan because it’s easy and requires no credit check. A click of a button, phone call or form will usually get the ball rolling.
Also, while interest rates vary from plan to plan, most rates hover between a reasonable 1 to 2 percent above the prime rate. Paying yourself the loan interest is also tempting if you’re investments are under performing the loan rate. Finally, the loan interest you pay yourself is tax deferred.
Heck, with those types of benefits, are there really any downsides? Plenty.
The biggest drawback to borrowing from your plan is that the money is no longer tax deferred. The payments you make to repay the loan, whether paid directly from a salary reduction or paid from your bank, are after-tax dollars.
So let’s say that your monthly loan payment is $400 and your marginal tax bracket is 30%, you will have to make $571.43 in gross salary to cover that payment. Worse yet, when you withdraw the money at retirement, you get to pay taxes again!
If you are younger than 59 ½ and default on your loan (which was YOUR money to begin with), you get to advance your taxes on the balance and pay Uncle Sam a 10% slap on the wrist penalty, as we discussed above.
Also, the interest you pay on your loan is not tax deductible as, say, a home equity loan would have been. Finally, dipping into your plan will warp your psychology toward retirement planning. Rather than saving for things you want or need, you may get in the habit of using your retirement as a spending fund.
So let’s see what happens in a real life scenario. Janie, age 30, has been a diligent saver and has accumulated $50,000 in her 401k. Between personal and employer contributions, she socks away $8,000 a year into her plan at an assumed rate of 7% per year. All other things equal, Janie will have accumulated $1,639,724 by age 65.
Janie decides to reward herself with a new car and borrows $25,000 from her 401k. The loan will be paid over five years at a rate of 4%, making her payments $460.41. During the term of her loan, she decides she can only afford 401k contributions of $206.26. After the loan is paid off, she begins her full $8,000/year contribution again. Janie should expect her nest egg to be $1,367,370 at retirement.
Her car loan resulted in an opportunity cost of $272,354!
Unless you plan to extend your working years or take up a part-time job during retirement, your 401k plan and all other retirement accounts should be off limits until you retire. Think of these funds as sacred. Using these accounts as a safety net is a great way to jeopardize your financial security in the future.
A better alternative is to build up a cash reserve outside of your retirement accounts. A true safety net consists of liquid savings, money market or CD accounts, not your retirement plan. Most brokerage firms or banks will allow you to establish a regular deposit schedule from your checking to your savings.
If a recurring savings program is not part of your reality, consider borrowing the money from somewhere else. If you are a homeowner with equity in your property, a home-equity loan may be your best bet. Make the most of the current low interest rate environment. Furthermore, your interest expenses may be tax deductible. If you are not a homeowner or have no equity, check out your local credit union. Credit unions, as opposed to some banks, typically have very favorable loan terms and fees.
Finally, if you have no other choice but to borrow from your 401k account, do yourself a favor and 1) pay back the loan as soon as possible and 2) continue to make your regular contributions in addition to your loan payments. After all, it’s only your future at stake.