The 401k plan is ubiquitous when it comes to retirement planning — millions of Americans regularly contribute to them. 401ks are pretty iron-clad savings vehicles as it can be difficult to withdraw money prior to your retirement age without hefty penalties and tax consequences.
However, many employers do actually allow employees to take out loans from their 401k accounts. And people take advantage of this — about 20% of plan participants currently have an outstanding 401k loan, according to the Employee Benefits Research Institute (EBRI).
But is taking a loan against your 401k really a good idea? Let’s take a closer look and explore what your options are when it comes to borrowing against your 401k.
Does it Make Sense?
Let’s address the elephant in the room first: Is it ever a smart idea to borrow money from your 401k? After all, the primary purpose of contributing to a 401k for most people is to save money for retirement. Could you be jeopardizing your financial security if you take out a 401k loan before you retire?
We generally say that yes, you possibly could put your future retirement security in danger. In fact, this is probably the biggest drawback to taking out a 401k loan. Borrowing money from your 401k means that you miss out on the potential earnings that could have accumulated in your account due to the long-term compounding of returns. We usually advise clients that the opportunity cost of borrowing against your 401k is simply not worth it in the long run and can have serious negative consequences on your ability to meet your retirement goals. To see what compounding interest can mean for your retirement nest egg over time, see “The Average 401k Balance by Age.”
Another reason that you should really avoid borrowing against your 401k if at all possible is that if you leave your job or are terminated before you’ve repaid the loan, you might have to pay income taxes and a penalty on the outstanding loan amount (if you are younger than 59½ years of age).
The Lowdown on 401k Loans: How do They Work?
While we almost always recommend against 401k loans, if you absolutely must borrow against your 401k, you’ll be glad to know that the interest rate is usually less than the rate on some other types of consumer loans. And since the interest accrues in your account balance, you’re paying it to yourself, not to a bank or other lender.
Filling out a 401k loan application can often be done online in a matter of minutes and the process doesn’t generate a credit inquiry or impact your credit score. There’s also a lot of repayment flexibility: IRS regulations require that 401k loans be repaid according to a five-year amortization schedule, but you can repay the loan faster if you want through payroll deductions.
In general, you can borrow up to $50,000 from your 401k or 50% of your vested account balance, whichever is less. There are no restrictions on the purpose for a 401k loan, so you can use the money for any reason you choose.
Some Reasons People Decide to Take a 401k Loan
- They need money for a home down payment.Saving up enough money for the down payment is one of the biggest obstacles many people face when buying a home. Due to special rules that allow more than 5 years to pay back a 401k loan used for a down payment, some people opt to tap their retirement savings for this purpose. However, buying a house may not always be the wisest financial decision, especially if you have to use your retirement funds to fund the purchase. For more on that, read our article “Renting vs. Buying: What’s the Smarter Move?“
- They’re coming up short on college savings.With student loan debt in the U.S. now exceeding $1.5 trillion, many parents are hoping to save enough for college that their kids can graduate debt-free. Some parents opt to use their 401k funds to help pay college costs, but we strongly advise against this. Remember, you can always borrow for education, but you can’t borrow for retirement. And you won’t be much help to your kids if you run out of money in retirement!
- They need to make major home improvements or repairs.Many people use home equity loans and lines of credit (or HELOCs) for these purposes, but some people decide to take a loan from their 401k instead because HELOC’s usually have adjustable interest rates. However, we’d still advise caution here because again, the opportunity cost from taking money out of your 401k will almost always be too costly to your retirement savings.
- They are facing large out-of-pocket medical expenses.Higher deductibles and copays mean large out-of-pocket medical costs for many people today, so this is another reason many folks seek out 401k loans.
Our Take: Weigh the Pros and Cons
There are pros and cons to borrowing money from your 401k that you should carefully consider before taking any action. However, as fiduciaries (which means we are legally obligated to act in your best interest), we would generally advise against taking a loan out against your 401k – it is usually just too costly, as missing out on compounding interest can make a much bigger dent in your retirement savings than you might imagine.
But everyone’s situation is unique, so your financial advisor can help you decide what will work best for your specific circumstances.
Need to talk to someone about a 401k loan or other financial concerns? Click here to see the wealth management services we offer here at Personal Capital.
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