In Rick Rodgers’ recent newsletter, Dos and Don’ts of Retirement Planning, he lists “Don’t borrow from a 401(k) to pay off debt.” In this post, we will dig further into the details of a 401(k) loan.
Many Americans are 401(k) rich and cash poor. When the unexpected happens and cash needs arise, it may be tempting to tap into that 401(k) to get you through a crisis. But is this a good idea? While we never recommend taking a premature distribution from a 401(k) (and paying taxes and a penalty), in some limited circumstances, taking a 401(k) loan may make sense. For those plans that allow it, a 401(k) loan can provide quick access to cash to get you through a crisis. But before you do it, it’s important to understand the costs and potential pitfalls.
What is a 401(k) Loan?
Some (but not all) 401(k) plans allow participants to borrow money from their accumulated balance in the plan. Generally, you can take out 50% of your vested balance up to $50,000 both penalty and income tax free. You can typically get the money in a few days at a competitive interest rate without needing to go through a credit check. The loan is paid back over the course of 5 years through automatic payroll deductions.
The Pros of 401(k) Loans
- They provide quick access to cash without a credit check.
- They generally provide competitive interest rates (usually a few points above the prime rate) regardless of your credit history.
- Since you are loaning from yourself, no interest is lost in the transaction since you will be “paying yourself back” the principal and interest. However, you will still be charged fees by the plan for the origination and servicing of the loan.
The Cons of a 401(k) Loan
- While the loan is outstanding, you are missing out on growth in your portfolio. Even a small loan could have a huge impact on your retirement when compounded over many years.
- Depending on the plan, you may not be able to make additional contributions while the loan is outstanding (other than your loan repayments). This could make you ineligible for any kind of matching program offered by your employer.
- If you leave your job while the loan is outstanding, the plan may require that the full balance of the loan be paid back within 60 days.
- Failure to pay back the loan will result in the IRS viewing the outstanding loan balance as a premature distribution from the plan and you will owe income tax on the distribution as well as a 10% penalty in the year you are unable to pay.
Generally speaking, you should avoid using your retirement funds for short-term cash needs.
The opportunity cost of taking money away from your retirement is huge, especially when compounded over the course of 25–30 years. However, in certain circumstances, such as when you need cash quickly and have no access to a loan at a competitive interest rate, borrowing from your 401(k) may make sense. If you are considering this option, you should review the specific provisions of your 401(k) plan and speak to a trusted financial adviser who can help you determine the most prudent course of action.
If you don’t need cash today, but find yourself 401(k) rich and cash poor, start saving outside your 401(k) in a high-yield savings account so that you can be prepared for emergency cash needs. Stashing away at least 3 months’ worth of expenses is a good place to start. Then you won’t even need to consider a 401(k) loan when the unexpected happens.