Investor column: The risk and rewards of using 401K loans for financial emergencies
Searching for cash when your family is in a financial bind is super stressful. Taking a loan from a 401K and 403Bs may allow escaping from severe short-term financial jams. So let’s explore the risks and rewards for tapping your 401K or 403B for a loan when you’re in a financial mess.
Solving financial distress isn’t about tapping retirement accounts for an expensive two-week vacation in Lake Buena Vista. We’re talking cash to stay current on a mortgage or avoiding foreclosure. Or maybe your child messes up big time and needs ten grand for a lawyer to fight a DUI. Tapping your 401K may allow lawyering for a shot at redemption and a better future.
Short term liquidity issues usually last for about a year or less. Funds from a 401K or 403B loan may be available for your financial rescue in less than two weeks.
Not all retirement plans allow loans. Programs may limit how much you can take as a loan. Allowable 401K and 403 B plans allow borrowing the greater of $10,000 or up to 50% of your vested account balance – or $50,000.
One significant benefit is you are paying your interest to yourself. The amount is likely much less than a bank loan. So obviously this is better than prohibitively expensive title loans. You are expected to pay bay this loan over a term of fewer than five years. Your loan repayment amounts start working and growing, hopefully again, for your future immediately.
Funds needed for a principal residence, if allowed, can be repaid in loans longer than five years. Manatee School Board, for example, offers employees 10 years to pay back a loan used to acquire a primary residence.
Sure ending financial distress is a huge positive, but there is a downside. Negatives include missed investment opportunities and triggering taxation and penalties if you default on your loan payment program.
Additional loans need adjusting by prior loans and repayments. Reduce, between the highest outstanding balances of all participant loans, during the 12 months ending on the day before the new loan’s outstanding balance on the date of the new loan.
When leaving your job, if you don’t pay back all loan proceeds within 60 to 90 days, then the loan becomes an early withdrawal. “86% of people leaving jobs don’t pay back loans within this window,” says The National Bureau of Economic Research. Defaulting causes the entire balance not paid back to be a deemed and taxable IRS distribution. Taxes plus penalties may exceed 30% or more.
Other things to consider:
- Amounts held in 401K and 403B assets are usually protected from creditors, but not quantities tapped for loans.
- Taking money from 401K or 403B may miss potential market gains.
- Some companies don’t allow new 401K contributions while you are repaying plan loans.
- Consider a hardship loan that’s allowed by the IRS that you’ll be taxed but won’t have a 10% penalty instead of a 401K or 403B loans.
Try keeping existing or starting new 401K or 403B salary deferrals while paying the money back. Stopping original contributions, ultimately, risks losing retirement income. Should you do this in your 20s, for example, you might forfeit accumulating as much as $380,000, assuming an 8% return on investment, or losing perhaps $24,000 a year in future retirement income. This example is for illustrative purposes only. The return isn’t indicative of any actual investment because investment results may differ substantially.
Jim Germer is a Bradenton CPA and financial adviser at 100 Third Ave. W. , Suite 130. Call (941) 746-5600 or email jim.germer@ceterafs.com. Securities offered through Cetera Financial Specialists LLC (doing insurance business in CA as CFGFS Insurance Agency) member FINRA/SIPC. Advisory services offered through Cetera Investment Advisers LLC. Cetera entities are under separate ownership from any other named entity.
This story was originally published January 6, 2020 at 6:00 AM with the headline "Investor column: The risk and rewards of using 401K loans for financial emergencies."