A recent report from Fidelity Investments, the nation’s top provider of workplace retirement saving plans, shows the number of loans against 401(k) accounts has increased. The portion of participants with loans outstanding increased two full percentage points in the second quarter of 2010 to 22%. The average initial loan amount was $8,650 with an average loan duration of three and half years.
We can speculate on the reasons why borrowing is up, but the more important question should be, Is it a good idea to borrow from your 401(k)? Some people believe this is the first place you should turn to for money because you are really just paying yourself interest. This is another retirement myth.
The custodian must hold 401(k) assets as collateral in a safe place until the loan is repaid. This money is usually kept in a money market, earning less than 1% in today’s market. The average rate charged against 401(k) loans today is close to 6%. That’s better than credit card interest, but you are still paying 6% and earning 1%. The difference is going to the custodian for servicing the loan.
The worst part of a 401(k) loan is the tax trap that can be created if you leave your employer while the loan is still outstanding. The loan must either be repaid as a lump sum or it will be considered a taxable distribution. Not only will you have to pay tax on the loan, but the amount may be subject to a 10% early withdrawal penalty if you are under age 55.
Borrowing from your 401(k) should be a last resort. Make saving for retirement a priority. The longer the money is left to grow in your 401(k), the easier it may be to reach your goal. You can avoid borrowing your retirement funds by building up your after-tax savings. Always keep adequate funds on hand to meet emergency spending needs. This will require careful budgeting and discipline.