Given that individuals are primarily funding their own retirement, and the money is technically theirs anyway, many people borrow from 401k plans as an alternative to traditional financing through banks or other lending institutions.
Loans are #1
I answer a LOT of questions online and without a doubt, the #1 question I answer goes something like this: I need to take out a loan from my 401k. How do I do that?
I believe people have the impression that since they are borrowing money from themselves, they are just paying interest back to themselves as well. And since they are paying themselves back, there is no impact to their retirement.
In fact, according to benefits consulting firm AON Hewitt, a little over 1/4th (26%) of 401k participants have a loan outstanding. While on the surface it may appear that borrowing from your 401k is borrowing from yourself, this transfer of money isn’t as clearcut as it would seem.
Borrowing from a 401k plan generally indicates bigger underlying issues of budgeting, spending and self-control. Robbing Peter to pay Paul doesn’t help you get ahead, it just shuffles the deck.
A report done by Fidelity Investments, lists the average 401k balance at around $91k at the end of 2014. Taking into consideration that this amount wouldn’t even cover a retiree’s health care costs, most Americans aren’t in a position to deal with the financial repercussions of borrowing from their retirement accounts, yet many do it anyway.
Whether it’s due to unexpected financial emergencies or ‘wants’ instead of ‘needs’, one thing is for sure -- 401k loans are on the rise. But just because it seems to be easy money, doesn’t mean that the option is right for your situation. Here are a few things to consider before borrowing from your retirement.
Prevent the Need to Borrow
As mentioned above, the funds in your 401k are monies that you have earned and contributed to your own account. So it’s easy to view those funds as ripe for the picking when your dollars are low. In some cases, taking a loan might even seem like the best option available -- for example, if you’re paying off high-interest debt and you have the ability to pay the loan back in a short amount of time.
But even in those cases, borrowing from your future self to cover current expenses should be a red flag for some underlying financial issues that need addressing. Maybe you will pay back the 401k loan in short order, but you have a spending habit that you have not confronted, so you will likely find yourself in the same position in the not-too-distant future.
The best plan is to avoid getting into situations where you need to borrow money in the first place. That means setting aside funds to help you manage those large recurring expenses that pop up. That also means reviewing your budget periodically to check for money leaks and/or unnecessary expenses.
Sometimes it means telling yourself ‘No’. That great dining room furniture that’s on sale is amazing, but that table won’t pay your medical bills when you are 80.
Statistics show that these days people are living longer than ever. This fact alone should be enough to make you think twice before dipping into the funds that will need to last you for the rest of your life. Living small now will help you avoid living small when you retire.
Understand the Consequences
If your budget is tight and you’re making large monthly payments on high-interest debt, borrowing from your 401k might seem like the best option to take some pressure off of your situation. But before you make a final decision, be sure you understand what you’re signing up for:
- If you take a loan from your 401k and then are terminated by your employer, you are responsible for paying back the entire outstanding balance within a certain time period -- typically within 60 days.
- Any amount that you do not repay will be considered a retirement distribution and will be subject to income tax and a possibly 10% early withdrawal penalty.
- Depending on your employer’s plan rules, you may or may not be allowed to continue making your normal pre-tax contributions. If your plan will not allow you to make new contributions while you have a loan outstanding, you won’t have the ability to increase your 401k balance.
Once you consider the taxes, potential penalties, and loss of saving opportunities that result from taking a loan from your retirement accounts, it doesn’t look as favorable of an option. Or does it. After all, the interest rates are substantially lower than an equivalent personal loan, right?
Maybe, but let’s remember a few other things.
By just comparing interest rates, you’re not taking into consideration the opportunity costs of borrowing from a 401k plan. When you take a loan against your retirement balance, you miss out on any compound growth that your investments would have otherwise earned in the market.
To further complicate matters, unless the loan is repaid quickly, you may be looking at a permanent setback to your long-term financial planning.
Another factor that you must account for is the loss of tax efficiency. For example, since your 401k loans are repaid with after-tax dollars, if you are in the 25% tax bracket, you would need to earn $125 for every $100 borrowed. In addition, since your money may be taxed again when it is withdrawn in retirement, you may be subject to double taxation.
BankRate has a great calculator to help you determine how much a 401k loan will really cost you.
It’s important to remember that the the primary purpose of your 401k plan is for retirement savings, not borrowing. That said, you should try to exhaust all available resources before looking to your retirement account for a loan.
For example, if you own a home and have equity in it, you might consider a home equity loan as an alternative. As an added benefit, the interest paid on the loan may be tax-deductible.
If you’re experiencing a particularly challenging circumstance or have a specific hardship, you may be able to take a taxable withdrawal from your 401k instead of a loan. In some of those instances you may be able to avoid the 10% penalty, even if you’re under 59½.
Consider the fact that many 401k participants take out loans to repay high-interest debt. There are other ways to tackle those obligations that doesn’t negatively affect your financial future such as taking on part-time work or looking into non-profit credit counseling agencies.
Non-profit credit counseling agencies can work with your creditors to establish repayment plans on any accounts that you’re having difficulty paying. This may allow you to get payments under control, eliminating the need to tap retirement savings.
The reality is, although your retirement funds may be tempting to use to handle an emergency, pay down debt, or pay for a large expense -- like a down payment on a home, you can’t look at it in the same way that you would any ordinary loan. Making the wrong decision on a 401k loan could easily be the difference between a worry-free retirement or literally working for the rest of your life. It’s not a decision to take lightly.
If you have questions about your retirement accounts or would like to discuss how you can pay off your 401k loan early, schedule a complimentary meeting with me to get your questions answered and hopefully gain some clarity on your financial situation. In the meantime, you can check to see if you are on track for retirement by trying the Retirement Checkup on my website.
Pamela J. Horack, CFP® of Pathfinder Planning LLC provides personal financial planning advice and asset management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.