Most employer-sponsored 401(k) plans make it fairly easy to borrow from your retirement savings. But is tapping into those savings a good idea?
Let’s take a look.
Most 401(k) plans permit loans. When allowed, you can borrow up to $50,000 if you have a vested 401(k) balance of $100,000 or more. If your balance is less, you can borrow up to half of your account balance.
In most cases, the loan term is up to five years, but longer-term loans may be allowed if loan proceeds are used to buy a home. The interest rate on such loans is typically 1-2 percent above the prime rate. Repayment usually occurs via payroll deduction.
There are several advantages to taking out a 401(k) loan. First, no credit check is required and there’s relatively little paperwork. Further, a 401(k) loan is not income-taxed, versus taking an outright withdrawal from your 401(k). And the interest rate on 401(k) loans can be significantly lower than rates on regular consumer loans.
However, there are significant disadvantages, most importantly: if you don’t pay the loan back according to its terms, the IRS will deem it a distribution taxed at your ordinary income-tax rate. If you’re younger than 59½ when this happens, you’ll also face an early-withdrawal penalty.
Also consider the fact that you’re technically reducing (hopefully temporarily) the amount you have invested in your 401(k). If your 401(k) investments appreciate during the term of your loan, you’ll miss what that loan amount might have earned by being invested.
Given that the S&P 500 (for example) has averaged 10.7 percent in the last five years, that opportunity cost could be significant.
Since most retirees and soon-to-be retirees have 401(k)s that are too small to begin with, taking out loans may compound this problem. According to a 2018 study by Vanguard, the average 401(k) balance among their clients is $103,866, and the median is $26,331.
Yet, according to an Employee Benefits Research Institute (EBRI) study, nearly 20 percent of all 401(k) participants have outstanding loans. This statistic has held true since the early 2000s.
Certainly, if the value of your 401(k) declines during the term of your loan, then having that loan could work to your benefit, but that’s not a good way to “time the market.”
Still, more people consider 401(k) loans near bear-market bottoms, when their finances are stretched, than after an extended bull market. It’s the opposite of what they should do, given they’ll lose out on the appreciation of their assets while the loan is outstanding.
If funds are needed for an immediate purpose for which you will quickly be reimbursed, then a 401(k) loan could make a lot of sense. However, if you need to borrow for longer than a year, consider a home equity line of credit (HELOC) instead, even if the interest isn’t tax-deductible, because a HELOC doesn’t face the same limitations or adverse tax consequences if you change jobs or lost your job.
And besides, with a HELOC, you still will gain (or lose) the entire amount on your real estate that you would have earned even without the loan.
The general financial planning rule of thumb is to consider a 401(k) loan as a last resort only, but it’s always best to consult with your financial planner on your particular situation, so you can feel confident you are making an informed decision.