Dipping into your 401(k) plan is generally a bad idea, according to most financial advisors. But that advice doesn't deter about a quarter of the people who hold one of these accounts from making a raid on their funds.
Some of these planholders withdraw money outright from their account, often under hardship provisions that allow such a discharge of funds. But about three times as many people instead borrow temporarily from their 401(k) (or a comparable account, such as a 403(b) or 457), according to data from the Transamerica Center for Retirement Studies.
Such a loan can seem alluring. Most 401(k)s allow you to borrow up to 50 percent of the funds vested in the account, to a limit of $50,000, and for up to five years. Because the funds are not withdrawn, only borrowed, the loan is tax-free. You then repay the loan gradually, including both the principal and interest.
That interest rate tends to be relatively low, perhaps one of two points above the prime rate, which is less than many consumers will pay for a personal loan. Also, unlike with a traditional loan, the bank or other commercial lender doesn't receive that interest, you do. Since the "interest" is returned to your account, that makes the cost of borrowing from your 401(k) fund essentially a payment back to yourself for the use of the money. These distinctions prompt some financial counselors to endorse retirement-fund loans, at least when you have no better options for borrowing.
Many more advisors, though, counsel against the practice, almost no matter the circumstances. Borrowing from your 401(k), the say, goes against almost every time-tested principal of long-term investing.
Why Borrowing Is (Usually) a Bad Idea
Here are eight major reasons why you should likely focus on keeping your 401(k) plan until retirement, rather than using it as a piggy bank for loans:
1. Repayment Will Cost You More Than Your Original Contributions
The leading purported plus of a 401(k) loan--that you're simply borrowing from yourself, for a pittance--quickly becomes questionable once you examine how you'il have to repay the money.
Keep in mind that the fund you're borrowing were contributed on a pre-tax basis. But you'll be paying yourself back for them with after-tax money. If you are in the 25% tax bracket, every $1 you earn to repay your own loan leaves you with only $0.75 toward repaying the loan.
Put another way, in such a tax bracket, making your fund whole again would essentially require one-quarter more work for every dollar you repay than was the case when you made the original contribution. And if your employer matched part or all of those original contributions, you'll need to work harder still, since there won't be any such match on your loan repayments.
2. The Low "Interest Rate" Overlooks Opportunity Costs
While you're borrowing funds from your account, that money won't earning any return on investment. Those missed earnings need to be balanced against the supposed break you're getting for lending yourself money, and at a low interest rate.
"It is common to assume that a 401(k) loan is effectively cost-free since the interest is paid back into the participant’s own 401(k) account," says James B. Twining, CFP®, CEO and founder of Financial Plan, Inc., in Bellingham, Wash. However, Twining points out that "there is an 'opportunity' cost, equal to the lost growth on the borrowed funds. If a 401(k) account has a total return of 8% for a year in which funds have been borrowed, the cost on that loan is effectively 8%. (That's] an expensive loan."
3. Your Fund Won't Grow During the Loan
If you borrow money from your 401(k) account, most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn't stipulate this, it's unlikely you'll be able to afford to make future contributions in addition to servicing the loan payment.
Such a freeze in additional funding will deprive the account of money that should, in the long run, multiply in value by many times through compound earnings. Most calculations suggest that your money will double, on average, every eight years. The gap in what you might have made will be wider still if your skipped contributions lead to missed matches to those funds by your employer--since such a perk essentially represents free investment money for you.
4. If Your Financial Situation Deteriorates, You Could Lose Even More Money
The drawbacks above assume you'll be able to make the scheduled payments to your fund on time and without undue hardship. And the vast majority--90%,in fact--of those who borrow from their 401(k) plans are able to do just that, according to a study by the Wharton Pension Research Council.
However, should you be unable to repay the loan, its financial implications go from bad to worse. That's because if you default on a 401(k) loan, the loan is converted to a withdrawal. As a result, unless you happen to qualify for a hardship withdrawal, the outstanding loan balance will be subject, at minimum, to taxation at your current income tax rate. If you're under age 59½, you'll also be assessed a 10% early withdrawal penalty on the amount you've borrowed.
5. A Job Loss or Departure Begins a Repayment Clock
If you quit or otherwise lose your job, you'll have only a mandated time within which you need to repay an outstanding loan from your 401(k) or other retirement fund. Tax reforms that went into effect in 2018 lengthened that time from the previous 60 days after leaving your job to the due date of your next federal tax return, provided that is at least 60 days from the departure from the job.
Still, leaving your employer when you have an outstanding 401(k) loan is to say the least restructive. You'll be forced to come up with the outstanding balance and, if you can't, the loan will be treated as an withdrawal, with all the attendant implications for paying income tax and penalties.
In addition, the presence of a loan you'll have trouble repaying soon could handcuff you to a job you no longer enjoy, or force you to pass up a better opportunity should one come along.
6. You Lose Your Cushion
Taking a loan from your 401(k) plan should only be done in the most dire circumstances after you have completely exhausted all other potential sources of funding. If you take money from your plan to fund a vacation or pay off higher interest loans, the money won't be there to borrow if and when you really need it.
7. It Suggests That You Are Living Beyond Your Means
The need to borrow from your savings is a red flag – a warning that you are living beyond your means. When you can't find a way to fund your lifestyle other than by taking money from your future, it's time for a serious re-evaluation of your spending habits.
What purchase could possibly be so important that you are willing to put your future in jeopardy and go into debt in order to get it? (For more insight, see Digging Out of Personal Debt and The Beauty of Budgeting.)
8. It Violates The Golden Rule of Personal Finance
The Bottom Line
If the idea of taking a loan from your 401(k) plan crosses your mind, stop and think before you act. Instead of short-changing your future to finance your lifestyle today, consider re-evaluating your current lifestyle instead.
Scaling back on your expenses will not only reduce the burden on your wallet, it will also increase the odds that a sound retirement nest egg will be waiting for you in the future. "I have never met anyone who told me that they wished they had saved less," says Chris Chen, CFP®, wealth strategist, Insight Wealth Strategists LLC, Waltham, Mass. "People think that they will make up a withdrawal later, but it pretty much never happens."
The average outstanding loan balance was 11% of assets. For plan participants in their 20s, the number is much higher, coming in at 26% of their savings, a percentage that drops as participants age, falling to 19% for those in their 30s, 13% for those in their 40s, and 10% for those in their 50s. The figure is just 8% for those in their 60s.Long-term investing (such as saving for retirement) is based on the idea that by putting time to work on your behalf, your money will grow.
401(k) plans permit each loan to be held for up to five years or longer. Therefore, if the loan is used to fund a first-time home purchase, loan holders not only lose out on what should have been an opportunity to nearly double their money, but they are also left unable to make up for the lost contribution and growth opportunities.Time Will Work Against You
If you not are not making contributions, not only is the entire balance that you borrowed missing out on any potential growth in the stock or bond markets,
Over time, their balance is unlikely to ever reach the total that it would have reached had contributions continued uninterrupted. (For more insight, check out Understanding the Time Value of Money)(For more insight, read Business Owners: A Guide to Qualified Retirement Plan Loans and Should You Borrow from Your Retirement Plan?.)