Admit it: You’ve pondered the possibility of tapping your 401(k) on at least one occasion.
Why should you wallow in high-interest debt or delay your dream of homeownership, you reason, when your retirement fund spilleth over? It is, after all, your money.
You’re hardly alone.
The Employee Benefit Research Institute, or EBRI, and the Investment Company Institute report that 21 percent of all 401(k) participants eligible for loans borrowed funds from their accounts in 2012.
The average unpaid balance was $7,153, according to the same report.
In some cases, borrowing from your future to finance other goals, including paying for uninsured medical expenses and avoiding financial emergencies, may make sense, says EBRI research director Jack VanDerhei.
“There are a large number of situations in which, if one had high rates on credit payments, you would be better off financially to borrow from your 401(k),” he says. “Certainly, avoiding bankruptcy would make it worth your while.”
Such loans, however, do carry serious consequences that all retirement savers should consider.
“Employees should think twice before tapping into their 401(k)s,” says Pam Hess, the former director of retirement research for Aon Hewitt Associates. “Employees should be sure they’re using the money to meet a need rather than a want, because even small loans can seriously diminish their long-term savings.”
401(k) loan rules
- Employee may borrow up to half of their vested account balance to a maximum of $50,000.
- Most loans must be paid back over a five-year period.
- If the loan is for the purchase of a primary residence, the term is usually 10 to 15 years.
Advantages of 401(k) loans:
- 401(k) loans are cheap and easy to obtain.
- The interest is usually based on the prime rate, plus 1 percent or 2 percent.
- There are no credit checks, little paperwork and no restrictions on what you are eligible to borrow.
- Monthly payments are automatically deducted from employee payroll checks.
- And the best part is (as is often hyped to borrowers) you’re paying yourself back with interest.
Hess, however, warns such statements mask the biggest downside to such loans.
Borrowing from your 401(k) can hurt you over time, she says. The employee is losing the compounded interest. Even worse, many people stop making new contributions during the payback period.
Too often, Hess says, 401(k) plans become a “revolving door with the same employees taking money out over and over again, many with multiple loans.”
Disadvantages of 401(k) loans:
- You’re paying the loan back with after-tax dollars; the interest you pay is not tax-deductible.
- Should you default on your loan, the unpaid portion of your loan will be treated as a distribution by Uncle Sam. It will be subject to ordinary income tax and the 10 percent early withdrawal penalty if you’re under age 59 1/2.
- Should you lose your job or leave the company, most employers require borrowers to pay back their 401(k) loans in full, usually within 60 days.
- If you are unable to pay up, the unpaid portion of your loan will be treated as a distribution, complete with taxes and penalties.
Like Hess, VanDerhei encourages retirement savers to explore all their options, including home equity loans, before tapping into their 401(k)s.
How a 401(k) loan affects long-term savings
A 30-year-old man with an annual income of $40,000 (assuming 3 percent annual raises) and a 401(k) balance of $45,000 contributes 6 percent per year to get his full employer match (3 percent).
Assuming a 7 percent investment return in his 401(k), his nest egg will grow to $1,188,091 by age 65.
If he borrows $8,000 at a 6.75 percent interest rate, however, and pays it back over five years without contributing to the plan during the payback period, his ending balance falls 14 percent to $1,020,845 at age 65.
Source: Hewitt Associates.
“Depending on the terms, it might be better to take out a home equity loan or you may have a life insurance policy with cash value to borrow against,” he says.