You can borrow from your 401(k), but is it the best solution to your money problems?
By John Riddle
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."
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 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.]
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.