When staring down a major financial decision, the first question we often ask ourselves is “what is the best way to meet this cost?” As we assess our situation, it is completely natural to look towards one of, if not the largest, numbers on your balance sheet, your 401(k). But how exactly do you access these dollars if the rules say you cannot, without penalty, until you are age 59 ½?
One way to access that money is through a 401(k) loan. While turning to your retirement account for a quick cash infusion might seem like an appealing option, it’s a strategy that’s best avoided under most circumstances. In this insight, I’ll explain why you should think twice before borrowing from your 401(k). But first, let’s break down exactly how 401(k) loans work.
How Does a 401(k) Loan Work?
401(k) providers frequently offer the ability to take a loan from your retirement account. Here is how they typically work:
- You may borrow up to 50% of your 401(k) balance, with a cap of $50,000
- Your plan is not required to have a loan provision. It is the administrator’s discretion to offer the feature
- Financial hardship is not required to qualify for a loan
- There is no underwriting and the loan is not reported to credit agencies
- You must repay the amount distributed back to the plan within 5 years (exceptions apply for the purchase of a primary residence)
- Interest paid is credited to your 401(k) not the administrator (although there may be a fee for the loan itself)
- The interest rate is established by commercial lending standards plus a small spread, but since you are both the lender and lendee, the interest cost essentially nets to zero
It’s no wonder a 401(k) loan seems like an appealing option. If the choice is paying interest to a bank or credit card company vs. paying yourself, a rational person would certainly choose the latter.
The Downside of Borrowing From Your 401(k)
Taken at face value, the 401(k) loan seems like a no-brainer. But like many financial strategies, you’ll start to notice some potential drawbacks when you look below the surface. The real cost of a 401(k) loan comes in three main forms:
- Foregone market returns. During the time you have borrowed from your 401(k), you will not be earning a tax-deferred return on these funds. Though markets are not guaranteed to appreciate, missing out on positive returns may be significant in the long run.
- Foregone employer match. Most 401(k) plans stipulate you will not be granted your company match until the loan balance is paid in full.
- Tax efficiencies. Even though you are paying yourself the interest, it is not deductible and is taxable upon distribution.
In economic terms, these are opportunity costs. Meaning you are paying off a debt over the 5-year period you could have been contributing, earning a match, and experiencing market returns within your retirement plan.
One final item of note: if you terminate employment, or fail to repay the loan within 5 years, the entire loan may be deemed a “non-qualified” distribution. In this case, you will be required to pay a 10% penalty (if you are under age 59 ½) and taxes on any applicable earnings.
When is a 401(k) loan appropriate?
401(k) loans may be a decent option but they should be carefully weighed against your alternatives.
For those with poor credit scores, limited access to other credit facilities, and insufficient required capital, a 401(k) loan presents an intriguing option to advance yourself money without difficult underwriting or exorbitant interest payments.
Planning for large costs and maintaining diligent savings, however, should be considered the preferred route. Remember, your 401k is a means towards long-term financial security and should be treated that way.
In any case, coordination is required when considering a loan from your retirement plan and counsel from your financial professional is recommended.
