Tapping into your tax-advantaged retirement savings seems like a desperate financial deal (because it is), but also a good decision in specific circumstances. It’s best to know what you’re getting into with 401 (k) loans in terms of time, repayment, and risk.
Many 401 (k) holders actually operate their accounts. According to 401k.org, about 20% of Americans eligible for a 401 (k) loan have one, with average balances of $ 7,600.
Your loan amount usually starts at around $ 1,000 and goes up to the lesser of half of your acquired account balance or $ 50,000. Although interest rates vary by plan, the most common is the prime rate plus 1%.
Unless you are borrowing to buy a home, you have to pay off most 401 (k) loans in full within five years, often on a monthly schedule. Usually, you repay directly from your after-tax paycheck and can repay in one go without penalty.
• Loans do not incur any income tax or penalty for early withdrawal unless you are in default.
• There is no credit check or lengthy application form, opening up options if your credit scores are bad.
• Most loans become available quickly and you can borrow for almost any reason.
• Most 401 (k) loans have lower interest rates than credit cards.
• You pay interest on the loan to yourself, not to a bank or other lender.
• To borrow money, you take it out of the investment in the market, thus losing the potential gains. Carefully calculate your potential losses.
• Borrowed funds are taxed twice. You earn and pay payroll taxes and use those after-tax funds to pay off the loan. In retirement, you pay taxes again, this time on the funds withdrawn. If you are in the 25% federal tax bracket, double the tax is extremely expensive.
• At the end of the day, you contribute less to your pension plan because part of the new contributions goes to repay the loan.
• Not all 401 (k) allow employees to borrow on accounts. Check with your human resources department before you even start to consider a loan.
• If you stop working for your current employer, your entire loan usually matures within 60 days, making your job security for the next five years an important consideration. The loan is in default if you cannot repay; you pay taxes on the unpaid amount and you incur an early withdrawal penalty of 10% until you reach the age of 59 and a half.
Consider a 401 (k) loan only if you exhaust all other financial resources, including home equity loans.
Having said that, sometimes a 401 (k) loan offers a fantastic solution. For example, a client of mine expects an inheritance in the next few months and wants to buy a new house immediately.
It makes sense for this client to borrow on his 401 (k) to cover the initial cost of the home loan and repay the loan in full once he gets the inheritance. This allows him to borrow funds inexpensively and retain the great benefits of his retirement plan. Again, the length of the repayment period is important.
Education and business capital are also often good reasons to consider – carefully – a 401 (k) loan. The point: make sure that what you stand to gain now justifies the risk to your future financial security.
Lon Jefferies, CFP, MBA, is an investment advisor with Net worth advisory group in Sandy, Utah, and a member of the ConsultingIQ Financial Advisors Network, which is a USA TODAY content partner providing financial news and commentary. Its content is produced independently of USA TODAY.