You can borrow from your 401(k), but is it the best solution to your money problems?
It's not unusual to think about borrowing from your 401(k) plan when you run into a financial challenge. By some estimates, nearly 30 million Americans have tapped their retirement savings early, according to financial security expert Pamela Yellen, founder of Bank On Yourself.
"The 401(k) has replaced our homes as our piggy banks. And a very pricey piggy bank at that," Yellen says. "Just because you can take a premature withdrawal or a loan from your 401(k) doesn't mean it's a good deal. There are many strings attached to it, including how much you can borrow, what you can borrow it for, and how and when you must pay it back. And if you leave your job for any reason, you'll typically have to pay the loan back in full, with interest, within 30 to 60 days, or you'll owe taxes and penalties."
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Cons of borrowing from your 401(k)
One of the biggest disadvantages that participants face when taking a loan from a retirement plan is that the dollars used to pay the interest on the loan from the account are taxed twice. According to Lloyd Sacks, managing director of Sacks & Associates and a certified financial planner professional, the first tax occurs when the participant earns the funds and pays income tax on that earned income.
"Then after-tax dollars are paid to the plan for the loan," he said. "Here is where the second taxation happens: The contributions that are used to pay for the loan interest do not create basis within the qualified plan and will be taxable again when the funds are distributed, generally at retirement. This is a consequence of taking a plan loan that is often overlooked, not only by participants of 401(k)s, but also by financial planners advising their clients."
Sacks believes that a home equity line of credit (otherwise known as a HELOC) is a better alternative to borrowing against your 401(k). "If you have available equity in your home, you may be able to take a loan from your home's equity to qualify for your loan. The loan interest for a HELOC may be tax-deductible; therefore, from a personal finance perspective, this is much more advantageous to an individual."
Leaving your job speeds up loan due date
Leaving your job before the 401(k) loan is repaid can make the loan due a lot sooner. Typically, you’ll have to have it paid with your federal taxes for the year.
Losing a 401(k) match also makes it harder to recoup your losses from the loan. You will be perpetually behind in market gains, and downtime without a match is money lost.
Pros for borrowing from your 401(k)
According to David Bakke, personal finance expert at Money Crashers, one of the main pros of borrowing from your 401(k) plan is that it gives you access to the resources you probably need to solve your short-term financial needs.
"There are a few bright sides," he said. "Such loans do not generate income tax or other penalties, provided you pay the loan off on time. The application process is rather simple. Plus, you can borrow money from your plan for anything that you want – there are no restrictions in this area. And 401(k) loans usually come with interest rates that are less than credit cards', which is a factor when determining your options."
Amanda Palumbo, a researcher for the Chamber of Commerce, said that other pros include having no official loan application or credit check and that the money can be obtained rather quickly. "And don't forget that interest rates for this type of a loan are typically lower than any interest you might find with a credit card or a personal bank loan." [Interested in employee retirement plans? Check out our best picks.]
Alternatives to 401(k) withdrawals
There are other ways to get money when you need it. In addition to borrowing against the equity in your home (which is often the best bet), you can get a personal loan. Personal loans are designed to help pay for personal expenses, which can include schooling, medical expenses, major household purchases and all kinds of other costs. Personal loans may have higher interest than a 401(k) loan, but they are simpler to manage and don't come at the cost of compounded interest in your retirement account.
Credit cards come with high interest, and there is a risk that you may run into difficulties paying down the balance. However, they might be a short-term option to manage unexpected costs, provided that you have a plan to pay off the balance within a reasonable amount of time.
Government assistance can help with many situations. Examples of assistance programs that are available include unemployment, disability, healthcare assistance, food assistance and education loans. Non-government assistance is available in many cases, too. Charities, foundations and businesses supply grants, advice and help in many forms that can empower you to overcome a financial burden without dipping into your retirement.
How often can you borrow from your 401(k)?
The maximum number of loans will be set by whoever manages the retirement plan. The government limits borrowing to 50% of your savings or a maximum of $50,000 every 12 months.
Robert R. Johnson, professor of finance at Creighton University's Heider College of Business and the author of numerous financial planning books, including Investment Banking for Dummies, believes that people who want to borrow from their 401(k)s should recognize that there likely are other options, such as delaying the purchase of a new home or car.
"One of the biggest behavioral biases that humans succumb to is the bias toward immediate gratification over delayed gratification," he said. "That is, our present selves tend to win over our future selves."
If you borrow from your 401(k), it is extremely important to understand the rules and ramifications of your decision. Although this may seem like the quickest and easiest way to access cash when you need it, the long-term consequences are often misunderstood and can be severe.