If you are thinking about borrowing against your 401 (k) plan you may want think twice. Nearly one in four workers with a 401 (k) or similar defined contribution plan have taken out loans totaling $70 Billion or almost one-fourth of contributions. Taking a loan against your 401k account can have a major impact on your ability to have sufficient funds available during retirement.
The limit for withdrawal amounts is the lesser of $50,000 or one-half of the balance in your 401k account. Generally after you receive the funds, you will pay back the loan via automatic deduction from your next pay check. Your employer is not required to offer 401k loans however they may limit what the loans can be used for. Typical restrictions include: (1) to pay un-reimbursed medical expenses ; (2) to buy a first-time primary residence ; (3) to pay education expenses for yourself, spouse, or child; or (4) to stop an eviction or foreclosure on your primary residence. The loan must be repaid over a five year term however, the term can be extended for a first-time home purchase.
Before tapping your 401k you may want to consider the following:
Pros of 401k Loans
You May Borrow Funds for Any Reason
Unlike an IRA where you only have access to funds via a hardship distribution, you may be able to borrow from the vested portion of your 401k account for any reason. If you are borrowing for a first-time home down payment, the bank will count this as debt. In addition, the payback term may be extended to a 10-15 year term.
You Will Pay a Competitive Interest Rate . . . To Yourself
One of the benefits of borrowing from yourself is you automatically qualify for competitive interest rates regardless of what your credit score is. Interest rates are typically close to the prime rate or the going rate for consumer loans. The entire amount of your loan payment, principle plus interest, goes directly to your investment account and not the bank.
Asset Protection in a Declining Equity Market
In a declining Equity Market the assets you removed from your account are protected from loss of value. As you dollar cost average your loan dollars back into your account, you are buying more shares per dollar as the per share price declines.
Cons of 401k Loans
Reduced Monthly Take Home Pay
Obviously, the immediate issue with a loan is that you have to pay it back so you will need to update your budget and plan accordingly for this. In addition, you will be paying this amount back over 5 years, 10-15 years in the case of a first-time home purchase, so it is important to be certain you will have sufficient income to make up for this loss of income.
Lost Investment Growth in Increasing Equity Market
The amount you withdraw from your 401k will be not be invested for your retirement from the date the funds are withdrawn until they are repaid. You are potentially missing out on substantial investment gains over that time period which you will never be able to recoup. Another thing to consider is you will be purchasing fewer shares with your monthly loan payment as the price per share increases. This share price “premium” will also reduce the potential investment gain going forward. In other words, had you not taken out the loan your per share price would be lower, giving you a bigger potential profit.
Not Being Able to Pay Back Loan
If you quit working for any reason or change employers, your loan must be paid back within 60 days. In addition, if you fail to repay the loan on time within the typical 5 year payback period, any unpaid portion will be treated as a taxable distribution and you will face a 10% early withdrawal penalty if you are younger than 59 1/2.
A loan from your 401k should be considered as a last option only after you have exhausted all other options for obtaining funds from other sources. You should not borrow from your 401k plan if you: plan on purchasing a luxury item or fund living expenses, plan on retiring soon or your future employment is in doubt.
Readers: Under what circumstances would you consider taking a loan against a 401k account?