Are 401(k) Loans A Good Solution?

According to Bankrate.com, 19% of Americans tapped their retirement savings last year to cover the cost of an emergency. Most people need to borrow money at some point, but is borrowing from a 401(k) plan the best solution?

Before you consider borrowing from a 401(k) plan, it’s a good idea to weigh the benefits versus the costs. Additionally, be aware that not all 401(k) plans allow employees to borrow from their accounts. Check with your H.R. department before you even begin to consider a loan.

On the surface it may look very attractive to borrow from your 401(k) plan. You can borrow up to 50% of your account value up to a maximum of $50,000. Further, borrowing from a 401k plan is unique in that you’re borrowing from yourself instead of from a third party. The interest and principal that you pay goes back into your plan.

Here’s a simple example that illustrates what you’re essentially doing by borrowing from your 401(k) plan. Assume that you place ten $10 bills in your right pocket. You then transfer the bills to your left pocket and place an IOU for $100 in your right pocket. Every month you return one $10 bill to your right pocket, and you utilize fifty cents from your piggy bank to pay the required interest.

As the example illustrates, the cost of borrowing from a 401(k) can be minimal. However, the individual in our example isn’t exactly getting ahead either. The problem is that you’re just shifting your own money around. You are missing the opportunity to build your 401(k) from an outside source in the form of new contributions, employer matches, growth, interest and dividends.

Taking a loan from your 401(k) has other costs. Most plan administrators charge a fee to prepare loan documents. A large administrator in Utah charges $75 to set up an employee loan. Worse, some employers won’t let you continue contributing to your 401(k) plan until the loan is fully repaid. Thus, you could forgo matching contributions – one of the greatest benefits of an employee retirement plan.

To pay back the money, you must set up a strict repayment schedule. The payback period cannot last more than five years (except for funds withdrawn for a home purchase), and you will typically make monthly payments using a reasonable interest rate – commonly the prime rate plus 1%. Many employers automatically deduct the loan repayment from the employee’s paycheck – with after tax dollars! Of course, this negates another one of the greatest benefits of a 401(k) plan in that you no longer get tax deferral.

If you leave an employer while you have a loan balance, you have to repay the entire outstanding loan balance. If you default on repayment, the IRS will treat the loan as a distribution. You will then be subject to income taxes and, if you are under 59 ½ years old, will have to pay a 10% penalty.

Before taking a loan from your 401(k), ask yourself why you want to borrow money. Reasons for borrowing money run the gamut from truly important things, such as medical expenses or buying a house, to things that merely feed our egos, such as hot new cars or exotic vacations. If you’re borrowing to buy something nonessential, you should consider a different source than a 401(k) plan. It’s not a good idea to replace appreciating assets (your 401(k)) with assets that depreciate.

Generally, I feel that a 401(k) loan should be considered only if it’s essential and all other financial resources have been exhausted. However, there are instances when a 401(k) loan can be a fantastic solution. For instance, I have a client who expects to receive an inheritance within the next few months. However, this client would like to purchase a new home immediately and needs funds for a down payment. It makes sense for this client to borrow from his 401(k) plan in order to cover the initial cost of the home loan and repay the loan in full once the inheritance is received. This enables this individual to borrow funds inexpensively but then not forfeit the great benefits provided by his retirement plan.