Thinking about tapping your retirement account? Money Girl covers everything you need to know 401(k) loans, including how they work, potential problems to avoid, and ten pros and cons to consider before taking one.
Amanda from Ohio says, “I’m a long-time Money Girl podcast listener and want to know if you could do a show on taking a loan from your employer-sponsored 401(k) plan. Is a 401(k) loan a good idea if you need quick access to cash, and what pitfalls should you look out for?”
Thanks for your question, Amanda! As the balance in your retirement account at work grows, it can be awfully tempting to tap it. But first, it’s critical to understand what your 401(k) offers and the IRS rules for borrowing from one.
In this post, you’ll learn 10 pros and cons of taking a loan from your 401(k) or 403(b). We’ll cover everything you need to know to understand how these loans work, potential problems to avoid, and tips for making wise financial decisions.
10 Pros and Cons of 401(k) Loans You Should Know
Let’s start with a 401(k) primer in case you’re not familiar with these accounts. A 401(k) retirement plan is one of the most powerful savings vehicles on the planet. Many small and large companies offer them. The 403(b) is similar in most ways but is available when you work for certain non-profit organizations such as churches and schools.
If you’re fortunate enough to work for a company or an organization that offers a retirement plan, it’s an incredibly valuable benefit that you should take advantage of. But many people ignore their 401(k) or 403(b). They may not understand how it works or mistakenly believe you must be an investing expert to use it.
You elect to have your company deposit a percentage or a flat dollar amount from each paycheck into your traditional 401(k) or 403(b) before taxes are taken out. That’s a nice benefit because you don’t pay tax on contributions or their investment earnings until you take distributions in retirement.
However, there’s another option called a Roth 401(k) or 403(b). With a Roth, you pay tax on your contributions upfront, but you typically don’t pay any tax on future withdrawals of contributions or investment earnings.
This taxation is similar to a Roth IRA. However, a Roth at work has a significant advantage because there’s no income limit. If you have a high income, you become disqualified from contributing to a Roth IRA, but that’s not the case with a Roth 401k or 403(b).
For 2019, you can contribute up to $19,000, or up to $25,000 if you’re age 50 or older, to a workplace retirement plan. Additionally, many employers encourage workers to save by “matching” contributions and depositing additional funds into their accounts. You choose how to allocate your contributions and matching to a variety of investment options such as stock funds, bond funds, and money market funds.
How a 401(k) Loan Works
Now, let’s get into the details of how a retirement plan loan works. A 401(k) loan isn’t actually a loan because there is no lender. It’s just the ability to tap a portion of your retirement account on a tax-free basis and repay it with interest.
Even the term “interest” can be confusing because you don’t earn money from a 401(k) loan. You pay yourself interest from your own funds. So, you transfer money from one pocket to another. The purpose of paying interest when you take a retirement account loan is to make up for lost growth while your “loaned” funds are not invested in the markets.
The first hurdle to getting a loan from your 401(k) or 403(b) is that it must be allowed by your retirement plan. Ask your benefits administrator or check the rules by reviewing the summary plan description (SPD) document, which you should receive each year. Due to the paperwork and time that’s required to administer retirement loans, small companies may not offer them.
If retirement plan loans are allowed, there’s a limit to the amount you can get: You can only borrow half of your vested balance, up to $50,000. For example, if you have an account balance of $60,000, the maximum you can borrow is $30,000. If your balance is $200,000, the most you can loan yourself is $50,000. You can even have multiple loans, as long as the total doesn’t exceed $50,000.
Retirement account loans come with a set interest rate and term spelled out in the plan document. The repayment period is typically five years, but it may be longer if you use borrowed funds to buy a home. You must make payments in equal amounts that include principal and interest, which get deducted from your paycheck.
If you repay a 401(k) loan on time, you don’t pay income tax or a penalty. However, one of the biggest problems with taking a loan from your workplace retirement account is that the outstanding balance is considered an early withdrawal if you don’t repay it on time. If you’re younger than age 59½, you’ll be subject to income tax plus an additional 10% penalty on the entire unpaid loan amount.
Additionally, if you leave your job or get fired, any outstanding loan balance is treated as an early withdrawal unless you repay it by the due date of your federal tax return. In other words, the repayment term will be significantly shorter. If you can’t repay the entire outstanding balance, you’ll have to pay income tax and the 10% penalty on any amounts that weren’t previously taxed.
Basics of a 401(k) Hardship Withdrawal
If your 401(k) or 403(b) doesn’t allow loans, or you need more than the allowable loan amount, you may be eligible to take a “hardship” withdrawal, if permitted by your plan. However, hardship withdrawals don’t have as much flexibility as loans.
Hardships are specific circumstances approved by the IRS. They include paying for college, buying a main home, avoiding foreclosure on your primary residence, or having unpaid medical or funeral expenses.
The downside of a 401(k) hardship withdrawal is that it comes with income taxes and a 10% early withdrawal penalty if you’re younger than age 59½. Plus, you can’t make contributions to your retirement account for six months. This restriction is meant to discourage participants from tapping retirement accounts in the first place.
Pros and Cons of Taking a 401(k) Retirement Account Loan
Now that you understand how a 401(k) loan works let’s review each of these 10 pros and cons for taking one.
1. You receive funds quickly.
Amanda mentioned needing quick access to your money, and this is undoubtedly a benefit of taking a 401(k) loan. You won’t need to file an application or submit years of income tax returns.
You’ll need to complete a loan document with the institution that administers your 401(k). It verifies the amount you want to withdraw, the account to deposit your funds, the interest rate, and repayment terms.
Your funds are usually available within about a week. So, when you need access to money quickly and also know you can pay it back on time, taking a 401(k) loan can be a good option.
2. You get a relatively low interest rate.
As I mentioned, the interest rate you pay goes back into your own retirement account, so it works to your advantage in the long run. Also, the interest rate you pay could be much less than for other types of debt, such as a personal loan or a credit card balance.
3. You don’t have a credit check.
Since there isn’t a real lender involved with taking a loan from your 401(k), your credit isn’t a factor. If your retirement account allows loans, you can get one no matter what’s going with your finances.
4. You can spend it as you like.
When you take a 401(k) loan, how you spend it is entirely up to you. However, as I previously mentioned, using a loan to purchase a home may qualify you for a longer repayment term. So, be sure to let your benefits administrator know if you use any portion of a retirement loan to buy, build, or remodel a home.
5. You have a short repayment term.
Unless you spend a 401(k) loan to buy a home, you typically have five years to pay it back. Repaying a loan within a relatively short period can make sure you keep your financial life on track with less debt and more money growing for retirement.
Depending on what happens in the markets, repaying a 401(k) loan with interest could leave you with more in the account than if you didn’t take a loan. Assuming you pay it back on schedule, it won’t be a taxable event and may have a positive impact on your finances.
6. You can’t borrow more than the legal limit.
As I mentioned, if your retirement plan does allow loans, the IRS sets the maximum at $50,000 or 50 percent of your vested account balance, whichever is less. And there may be a minimum loan amount, such as $1,000.
Your vested balance is the amount of money in the plan that you own. You’re always 100 percent vested in retirement contributions that you make. However, you may not own some or all of the contributions that your employer made, such as matching contributions> or profit-sharing.
So, check your plan document or ask your benefits administrator for details if you’re not sure what your vested balance is. If you need to borrow more than the legal limit, you’ll have to look for other lending options.
7. Your payments must be deducted from your paycheck.
You can’t make a lump-sum repayment for a 401(k) loan. Your payments are set up through automatic deductions from your paychecks. Most plans allow for monthly or quarterly payments.
So, be sure you know what your loan payment amount will be and that you can afford it. Missing a payment means that your entire outstanding balance could be considered an early withdrawal, subject to taxes and a hefty penalty.
8. You must pay non-deductible interest.
As I’ve covered, money that you borrow from your 401(k) or 403(b) is penalty-free if you follow all the rules – but it’s not interest-free. The interest you pay gets added to your account balance, and the rate is specified in your plan document. The loan plus interest must generally be repaid within five years.
Also, note that the interest you pay on a retirement plan loan isn’t tax-deductible. If you plan to use the money to buy a home or pay for education, you’d be better off getting a mortgage or a student loan. These products allow you to deduct all or a portion of your interest from your taxable income.
9. You miss out on potential market gains.
The purpose of having a retirement account is to allow your money to grow for the future. Funds you withdraw for a loan will miss out on that potential growth.
Even if you repay the loan on time, you could likely come up short. Since you don’t know what will happen in the markets, you can’t know for sure how much growth you’d miss.
10. You could have an expensive late payment.
If you take a 401(k) loan and something unforeseen happens, such as having a financial hardship or losing your job, you could end up in a tight spot. Separating from your employer for any reason means that your entire loan balance is due by the tax filing deadline. Otherwise, it’s considered an early withdrawal if you’re younger than age 59½.
So be sure that all is well with your job before you decide to take a retirement account loan.
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Should You Take a 401(k) Loan?
Whether you should take a loan from your 401(k) or 403(b) depends on your circumstances and how you plan to use the money. Let’s say your job is secure and you’re younger than 59½. If you were to take a loan from your 401(k) at 5% interest, that would be a better option than taking a hardship withdrawal and paying income tax plus a 10% penalty.
Another consideration is that workplace retirement plans have protection from a federal law called the Employee Retirement Income Security Act of 1974 (ERISA). It sets minimum standards for employers and plan administrators. One of the key safeguards it gives you is protection from creditors.
For instance, let’s say you have money in an ERISA-qualified account and lose your job and can’t pay your car loan. If the lender gets a judgment against you, they can attempt to get repayment from you in a variety of ways, but not by getting into your 401(k).
There are exceptions when a qualified ERISA plan is at risk, such as when you owe the IRS for federal tax debts, owe criminal penalties, or owe an ex-spouse under a Qualified Domestic Relations Order. But having money in a retirement plan at work gives you unique protections in the event you have a financial catastrophe.
For all these reasons, I recommend not taking money out of your retirement plan if you can help it. Consider other options –such as getting a mortgage, a home equity loan, a student loan, or using money in your IRA – before borrowing from your 401(k) or 403(b).
If your retirement plan offers a free consultation with an advisor, take advantage of the opportunity to get customized advice, and ask questions about your options. Think carefully about the pros and cons of a 401(k) loan before draining your retirement account.
Published by Debt.com, LLC