When looking to buy a house or just needing some quick cash, it’s not uncommon for people to look to their retirement accounts for easy money. Show
I usually advise against this and feel it can cause more damage to your financial security than good, and I’d like to explain why. Spoiler alert: we’re going to be doing math. What is a 401(k) loan?First, what does this mean? A 401(k) loan means borrowing from the money you’ve been putting aside for retirement. Most traditional plans will allow you to borrow up to 50% of your vested funds up to $50,000 at a relatively low interest rate for up to five years. You will need to repay the money you borrowed plus interest, and the interest is paid into your account. Sounds like a solid plan, right? Not exactly, and here’s why: Pre-tax versus post-tax dollars.When you contribute to a traditional 401(k), you’re putting money in that has not been subjected to tax. And, because it’s not technically a withdrawal, you’re not paying taxes on the money you take out. So, you take out $10,000 and plan to pay it back in five years. The interest rate is 5%, which isn’t terrible. You set up a payment plan to pay $192.48 each month for five years for a total of $11,548.80 in payments MORE FROMFORBES ADVISOR Best Travel Insurance CompaniesByAmy Danise Editor Best Covid-19 Travel Insurance PlansByAmy Danise Editor The money you are using to pay back yourself is going to be post-tax dollars. So, if you’re combined federal and state income tax bracket is 25% (just for simple math), you’re effectively paying 25% more than just the nominal principal and interest payments. It will take $15,398.40 of earned income to pay back the loan, including the income taxes and interest, with $3,849.60 of that going straight to the government. The loss of growth.While you’re paying back that loan, you’re losing the opportunity for it to be growing. Say you leave that $10,000 in the account and it grows at 7% (again, just making up these numbers). Thanks to compounding, that $10,000 would actually equal $14,025.52 after five years. So by taking that loan, you spent an additional $3,849.60 in taxes and lost out on $4,025.52 of potential appreciation for a total opportunity cost of $7,875.12 on a $10,000 loan. Plus, some plans won’t allow you to continue contributing to your account while you’re paying back the loan, so you could be losing another five years of tax-deductible savings. Then what?You borrowed from your 401(k). You lost thousands to taxes and opportunity costs. But you’ve managed to pay it back. Now what? You just lost five years of contributions to your account. Five years that could’ve been used for compounding your account balance. When it comes to building wealth, time is your most valuable resource. The compounding power of interest can be the difference between gaining an extra comma in your account or not. It could be the difference between retiring at 50 and retiring at 65. Unless your need to borrow funds is for an absolute emergency and you have nowhere else to turn, your 401(k) should remain untouched. Other options.I wouldn’t steer you away from one solution without at least suggesting alternatives. There are a few creative ways you can find money outside of your retirement plan. If you own a home, a home equity line of credit can be a great way to borrow money at a low rate that won’t cause the same financial destruction. For those who have family members with healthy savings accounts or Certificates of Deposit, outlining an intra-family loan could actually bring in extra cash for your relative while getting you the money you need. Even the highest interest savings accounts are generally only yielding half a percent. Instead, ask your relative for the $10,000 you need and offer to pay it back with just 2% interest. This small change in yield will raise their annual income from $50 to $200. As long as you stick to your payment plan, you can handle your finances and not ruin Thanksgiving. If neither of those options are viable, a basic personal loan may have a slightly higher interest rate, but it will still cost you less overall due to income tax considerations. The lesson:Borrowing from a 401(k) seems simple, and the low interest rates and easy access can make it tempting. But retirement is the only expense in your life that you cannot borrow for. With pensions being nearly extinct and Social Security struggling to hang on, you will likely only have your savings to get you through your golden years. One of my first positions was in a 401(k) call center, where one of the most common questions people asked was about taking a plan loan to pay off their credit card debt. What Rob Gronkowski Can Teach Us about Saving for Retirement When I went to my manager for guidance, I was told in no uncertain terms that we were never ever to broach this topic, as it bordered on financial advice. Throughout my career I have seen that employers refuse to discuss 401(k) plan loans as a source of debt financing. To the extent plan materials provide any advice regarding loans, the message is usually centered on the dangers of borrowing from your retirement nest egg. The reluctance to communicate the prudent use of 401(k) plan loans can be seen in the number of people holding different types of debt. Subscribe to Kiplinger’s Personal FinanceBe a smarter, better informed investor. Save up to 74% Sign up for Kiplinger’s Free E-NewslettersProfit and prosper with the best of Kiplinger’s expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail. Profit and prosper with the best of Kiplinger’s expert advice - straight to your e-mail. Sign up While numbers vary, 22% of 401(k) plan participants have a 401(k) loan outstanding, according to T. Rowe Price’s Reference Point 2020 (opens in new tab). Compare this to 45% of families holding credit card debt and 37% having vehicle loans (source: U.S. Federal Reserve Board Summary of Consumer Finances (opens in new tab)). Yet the interest rate charged on 401(k) plan loans is typically far lower than other available options. The annual interest rate of plan loans is typically set at Prime Rate +1%. As of March 2021, prime +1 is 4.25 (opens in new tab)%. The average annual percentage rate (APR) on credit cards (opens in new tab) as of March 2021 is 16.5%. And depending on your state, payday or car title loans (opens in new tab) have an APR varying from 36% to over 600%! The basics of how it worksParticipants in an employer-sponsored defined contribution program, such as a 401(k), 457(b) or 403(b) plan, can typically borrow up to 50% of their plan account balance, up to $50,000. Loans other than for purchase of a personal residence must be repaid within five years. Repayments are credited to your own account as a way to replenish the amount borrowed, and there are no tax consequences so long as the loan is repaid. What’s at stakeI still think about my call center experience and wonder why we couldn’t have been more helpful. I would never recommend tapping your retirement savings to pay for current expenditures, but the need for short-term borrowing is an unfortunate reality for many people. If you have to borrow, why not at least examine the advantages of tapping your plan over other short-term financing options? Besides lower interest rates here are some potential advantages of 401(k) loans:
Of course, there are disadvantages as well, including:
Good newsFinal regulations have been issued by the IRS on a provision (opens in new tab) (Section 13613) of the Tax Cuts and Jobs Act of 2017 (TCJA) extending the time that terminated employees can roll over their outstanding 401(k) loan balance without penalty. Previously, you had 60 days to roll over a plan loan offset amount to another eligible retirement plan (usually an IRA). The new rules stipulate that effective with loan offset amounts occurring on or after Aug. 20, 2020, you have until the due date (with extensions) for filing your federal income tax return, to roll over your plan loan balances. Why I Tell My Clients to Use Mint When Planning for Retirement By way of example, if you leave your job in 2021 with an outstanding 401(k) plan loan, you have until April 2022 (without extensions) to roll over the loan balance. Make the right choice – but tread carefullyAfter all other cash flow options have been exhausted — including such possibilities as reducing voluntary (unmatched) 401(k) contributions or reviewing the necessity of any subscription services which are automatically charged to your credit card - ,) — participants should compare plan loans to other short-term financing options. Some of the points to specifically consider include:
Again, no one advocates this type of borrowing except if it’s more advantageous than your other alternatives. So, if your employer isn’t walking you through the pros and cons of a taking a loan against your 401(k), investigate them for yourself. With Money, What You Do Matters More Than What You Know This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA. Do you get the interest back on a 401k loan?Pros: Unlike 401(k) withdrawals, you don't have to pay taxes and penalties when you take a 401(k) loan. Plus, the interest you pay on the loan goes back into your retirement plan account.
What is the downside of a 401k loan?A 401(k) loan has some key disadvantages, however. While you'll pay yourself back, one major drawback is you're still removing money from your retirement account that is growing tax-free. And the less money in your plan, the less money that grows over time.
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