The Risks of Taking a 401(k) Loan
Most 401(k) plans allow participants to take a loan from their account, and many workers do. An average of 13,000 401(k) participants take a loan each month for a median of about $4,600, according to an analysis of 900,000 401(k) participants by the University of Pennsylvania's Pension Research Council. About 10 percent of borrowers default on their 401(k) loans, typically due to an unanticipated job change. These loans are also subject to limits, fees and penalties. Here's what to watch out for when taking out a 401(k) loan:
Borrower limits. Participants in 401(k) plans are eligible to borrow up to 50 percent of their vested account balance (up to $50,000 if their plan permits loans). That means you'll need to have at least $100,000 in the plan to borrow $50,000. If your account balance is $40,000, the most you can borrow is $20,000. And the loan amount may be further reduced if you took another 401(k) loan in the past year.
Short repayment period. Typically, loans from 401(k) accounts must be repaid within five years. However, if the loan is used to purchase a home, the repayment period can be extended. Regular loan repayments must be made at least quarterly over the period of the loan. However, repayments can be suspended for employees performing military service. Payments can also be delayed during a leave of absence of up to a year, but higher payments or a lump sum will be due upon your return and the original five-year term of the loan still applies.
Penalties for missed payments. A loan that is not paid back in regular payments within five years is treated as a distribution from the plan. This means the entire outstanding balance of the loan becomes subject to income tax. For workers under age 59½, a 10 percent early withdrawal penalty will also be applied to the loan balance. Missed loan payments can often be prevented by having the money automatically withheld from your paycheck.
%VIRTUAL-article-sponsoredlinks%Leaving your job. If you lose your job or find a new job at another company, the outstanding loan balance may become due. If you are unable to repay the loan, the loan becomes a distribution and taxes and penalties may be applied to it. "You may have another opportunity you want to go to, and your loan may limit that activity," says Eric Toya, a certified financial planner and director of wealth management at Navigoe in Redondo Beach, California. "Or you may lose your job, and then not only have you lost your job, but this loan turned into a withdrawal that you owe a whole bunch of taxes on." Another way to avoid the tax consequences if you have the cash is to deposit the outstanding loan balance in an individual retirement account or other retirement plan within 60 days.
The opportunity cost. When you take a loan from your retirement account, you miss market gains you could have benefited from if you left your money in the account. "If you have a $100,000 401(k) and you borrow $25,000, you basically have $75,000 participating in the market," Toya says. "If the market goes up 10 percent, then you are gaining $7,500 versus $10,000. If the market goes down, you could say you saved money, but then when the market goes down, it is generally a great time to be adding money to the portfolio. And that is generally not happening when people are taking 401(k) loans."
Loan expenses. The interest you pay back to yourself isn't the only cost of a 401(k) loan. Participants in 401(k)s who take out loans must often pay origination, administration and maintenance fees.
Double taxation. Traditional 401(k) contributions are made with pretax dollars, and the money is not taxed until you withdraw it from the account. But loan repayments of both principal and interest are made with after-tax dollars. "This results in double taxation of the interest piece, since when you retire, you'll need to pay tax on the full benefit from the plan, a portion of which is due to this after-tax interest you paid for the loan," says Olivia Mitchell, director of the Boettner Center on Pensions and Retirement Research at the University of Pennsylvania's Wharton School and co-author of the Pension Research Council report. "In most cases, the opportunity cost of plan borrowing plus the double taxation of the interest from a plan loan will still be less than, say, borrowing on a credit card or payday loan."
Less retirement savings. A 401(k) loan ultimately reduces the amount of money you will have in retirement. "The need to borrow from a 401(k) plan is usually a symptom of a deeper problem with a person's financial situation," says Michael Garber, a certified financial planner for Michael Garber Financial Planning in Sunnyvale, California. "Before considering taking a 401(k) loan, take a look in the mirror and see if there are changes you can make first to better enable living within your means."
If you absolutely need the money, you could compare the fees and interest rate on a 401(k) loan with loans from other financial institutions you qualify for. Borrowing from your 401(k) will certainly hurt your retirement account's growth and reduce the amount of money you have at retirement, but the terms might be better than other higher-cost forms of debt, assuming you can hold onto your job until the loan is paid off. "Most people cannot borrow at interest rates as low as they can usually get from their 401(k) plans," Mitchell says. "Of course, if the borrower ends up not repaying the loan due to job termination and then pays a fine, the full cost can be much higher."
Emily Brandon is the senior editor for Retirement at U.S. News. You can contact her on Twitter @aiming2retire, circle her on Google Plus or email her at firstname.lastname@example.org.