It’s a big, enticing pot of money sitting there, available for tapping to meet current needs. And hey, you’re not draining your 401(k); you’re only taking a loan against it and not robbing your retirement security. AdviceIQ Network member Roger Wohlner, a fee-only financial adviser based in Arlington Heights, Ill., sketches out why 401(k) loans are a very bad idea:
Many 401(k) plans allow you to take a loan against what you saved. Such money, though, comes with catches. Overall, tapping your tax-advantaged retirement savings is a bad idea because it saps your retirement kitty.
First, the organization sponsoring your plan, probably your for-profit employer, decides whether to allow loans and what you can use the loans for. Typical reasons for loans include college expenses for your children, medical expenses, purchase of a home or to prevent eviction from your home. The flexibility inherent in allowing loans is often touted as one of the good features of the 401(k).
According to 401k.org, about 20% of Americans eligible for a 401(k) loan have one, with balances averaging $7,600. The amount of your loan usually starts at about $1,000 and maxes out at the lesser of half your vested account balance or $50,000. While interest rates vary, plan to plan, most common is the prime rate plus 1% -- significantly cheaper than rates for most credit cards.
The loans incur no income tax or penalties for early withdrawal unless you default. Perhaps the best point: You pay interest on the loan to yourself, not to a bank or other lender. Defaults are not reported to credit agencies.
Rules govern how you can use the loans, the number of loans you can keep outstanding at one time and how much of your account balance you can borrow. Unless you borrow to buy a home, you must fully repay most 401(k) loans within five years; you can repay all at once with no penalty.
But when calculating such a loan, which online calculators like those of bankrate.com can help you do, realize that borrowing from your 401(k) also carries downsides:
Leaving your job triggers repayment. If you depart with an outstanding loan against your 401(k) account, the balance can become due and payable immediately. This applies whether you leave your job voluntarily or involuntarily.
Though your regularly scheduled repayments are deducted from your paycheck while you’re working, you need to come up with the funds to repay the loan when you leave your job, or the balance becomes a taxable distribution. If you are younger than 59½, you may also pay a 10% penalty.
Costs of a rising market. Loan repayments do carry an interest component that you essentially pay to yourself as you repay money into your 401(k) account. But the interest rate might be much lower than potential returns and earnings on your investments in the plan during a rising stock market.
This can lead to a lower balance at retirement and a lower standard of living, possibly meaning that you must work more years than you planned. Obviously, this scenario also depends on market conditions and your investing patterns.
Charges. You pay a surcharge for loan origination, administration and maintenance. Also, even if you want the loan to buy your principal residence, you cannot deduct interest on 401(k) loans on your tax return.
No repayment flexibility. The payments come from your paycheck, which of course reduces the money you bring home each pay period. If you run into financial difficulty, you cannot change the terms of the loan repayment.
Temptation to trim 401(k) contributions and deferrals. That you repay the loan from your paycheck might cause you to reduce the amount you save for retirement via your salary deferral to the plan. Budget carefully.
Less money at retirement. A loan against your 401(k) plan results in smaller nest egg at your retirement. This potential only adds to the difficulty many already face accumulating a sufficient amount for retirement.
Avoid 401(k) loans especially if you:
• are near retirement;
• feel that your job is in jeopardy or you plan to leave your job soon;
• are already behind in saving for retirement;
• have other sources to obtain the money, such as a home-equity loan; or
• feel that repaying the loan will be a financial hardship.
Sometimes you can’t avoid taking a loan from your 401(k); the past few years’ economy was tough for many. If at all possible, though, avoid these loans and instead let that money grow for your retirement.
