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Looking for a Loan? Think Twice Before Tapping a 401(k)

With a stagnant economy and money tight for many families, it’s only natural that some people may consider borrowing from their 401(k) retirement plan if they need some extra cash. After all, it’s your money, right? True, but it’s important to consider the potential negatives of borrowing from yourself in this way.

By law, loans are allowable from a 401(k) plan. However, it is up to your employer whether it is allowed in your plan. The amount allowed by law is 50% of your vested balance up to a maximum of $50,000. There are no restrictions by law as to what you can borrow money for, but employers can impose their own restrictions. The loan must be repaid in five years on an amortizing basis unless you are borrowing to buy a first-time residence where a longer payback period is allowed. However, interest is not tax deductible as it is with a normal mortgage.

401(k) loans are convenient, requiring no credit check and a minimum of paperwork. Application fees are generally low or nonexistent. Plans generally offer an attractive interest rate. You are paying interest to yourself. Payments are generally done through payroll deduction. Those are the pluses, and yes it is easy.

As a Financial Planner I do not like loans from 401(k) plans except when there is an extreme liquidity need, perhaps triggered by some unforeseen event. Never should it be used for normal living expenses. If you are using the 401(k) properly by funding the maximum and investing on a planned basis, by taking a loan you are interrupting the flow of the account. If you have the loan during a bear market, even your low rate of interest will be a positive, but during a bull market it works to your detriment.

When you have a loan to repay you may be tempted to reduce the amount of your regular contribution or you just may not have the funds to do both. A further negative is that you are paying back the loan with after-tax dollars. You will pay tax on that same money again when you take a distribution in retirement.

If you leave your present employer, you will be required to pay off the loan, generally within 60 days. If you are unable to pay back the loan, it becomes a distribution, subject to income tax, as well as early distribution penalties if you are under 59½. Under any circumstance, not repaying the loan is deemed a distribution with all the associated taxes, which further diminishes your savings. Loans must be paid off before any regular or required distribution can be taken.

My concern is that many people are going to lack the financial ability to retire and maintain their lifestyle. Taking a loan from your plan may interfere with achieving your goals. If you have a financial need, consider if there are any other available sources that may be more advantageous than borrowing from your 401(k). It may pay off in the long run.

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Posted in Financial Education.

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