Most employer-sponsored 401(k) plans make it fairly easy to borrow from your 401(k).
But is tapping into your retirement savings a good idea? Here are the pros and cons.
Most, but not all, 401(k) plans permit loans. When they are allowed, you can borrow up to $50,000 from your 401(k) plan if you have a vested account balance of $100,000 or more. If you have less than that, you can only borrow up to half of your account balance. In most cases, you can borrow for a term of up to five years, but longer-term loans may be allowed if you'll use the money to buy your home. The interest rate on the loan typically is set at 1-2 points above the prime rate. And you typically pay it back by taking a portion of each paycheck and applying it toward your loan.
There are several advantages to taking out a 401(k) loan. First, there is no credit check done to get the loan and there is relatively little paperwork. Further a 401(k) loan won’t be taxed when proceeds are received, versus if you took an outright withdrawal from your 401(k). And the interest rate offered on a 401(k) loan is often significantly lower than the interest you’d have to pay on regular consumer loan.
However, there also are significant disadvantages, most importantly: if you’re not able to pay back the loan according to its terms, the IRS will consider it as a taxable distribution taxed at your ordinary income-tax rate. If you’re younger than 59½, when this happens, you will also face an early-withdrawal penalty. Also, you need to consider the fact that you’re not really borrowing from your 401(k) but actually reducing (hopefully temporarily) the amount you have invested in your 401(k). If your 401(k) investments appreciate during the term of your loan, you will miss out on what that loan amount might have earned by being invested.
For example, if you took out a $50,000 loan from your 401(k) 5 years ago when it was 100% invested in the S&P 500 ETF “SPY” and since then, the SPY rose over the last five years at a 10.7% annualized rate, your loan meant that you missed out on appreciation worth more than half that loan amount. The “cost” of your 401(k) loan was therefore much higher than the actual interest rate you would have had to pay.
Since most retirees and soon-to-be retirees have 401(k)s that are way too small to begin with, taking out loans can just compound the problem. According to a 2018 study by Vanguard, the average 401(k) balance among their clients is just $103,866, and the median is just $26,331.
Yet, according to a study by the Employee Benefits Research Institute (EBRI), nearly 20% of all 401(k) participants have outstanding loans. This statistic has held true since the early 2000s.
Certainly, if the value of your 401(k) declines during the term of your loan, then having that loan could work to your benefit, such as for those who took out a loan from their 401(k) in 2007, before the Great Recession, but that’s not a good way to “time the market!” Still, more people consider 401(k) loans near bear-market bottoms, when their finances are stretched, than after an extended bull market, which is the exact opposite of what they should do, given that they will end up losing out on the appreciation of their assets during the terms of their loans.
If funds are needed for a quick purpose, such as advancing funds for which you will quickly be reimbursed, then a 401(k) loan could make a lot of sense. However, if you need to borrow for longer than a year, you may want to consider a home equity line of credit (HELOC) even if the interest isn’t tax-deductible anymore, because a HELOC doesn’t face the same limitations or adverse tax consequences if you change jobs or are laid off. And besides, with a HELOC, you still will gain (or lose) the entire amount on your real estate that you have earned without the loan.
The general financial planning “rule of thumb” is to consider a 401(k) loan as a last resort only, but it’s always best to consult with your financial planner on your particular situation, so you can feel confident you are making an informed decision.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual nor is it intended as tax advice.