For many consistently employed workers, the 401k represents their most consistent form of saving. It is also tends to hold the majority of retirement savings. It can be tempting to draw on these funds if there is a major financial event in your life, such as buying a new home, remodeling an existing house, buying a new car, or maybe you’re just trying to weather some tough financial waters.
However, in most cases, this is a poor financial decision. In this post, we’ll look at what happens when you take a loan against your 401k account, and why taking a 401k loan can be a costly decision.
How a 401k Loan Works
401k plans are each individually administered with their own policies and rules. However, there are common guidelines and best practices that are used by most. We’ll assume that your plan is a fairly typical one for the sake of simplicity. When you want to take a loan against your 401k, you will essentially be removing money from your retirement account with the expectation of repaying that money along with some interest.
Generally, the term of the loan is five years. Loans for home purchases are sometimes given favorable treatment, and allowed to be paid back over the course of 10 years. The amount it can loan out is also limited. The Internal Revenue Service generally limits the amount a participant’s plan can loan out to a total of $50,000 or half of the participant’s vested balance, whichever is smaller. For the interest payments, the plan administrators must set a “reasonable” interest rate that reflects the market rate for similar loans.
Your interest rate is usually not affected by your credit score. In practice, 401k plan administrators tend to set the interest rate at 1-2% over the prevailing prime rate. How you pay back the loan will depend upon how it is arranged, but most of the time you have the option of having the payment taken directly out of your regular paycheck.
Drawbacks of 401k Loans
Market Gains and Compound Growth
Of the many reasons to not take a loan against your retirement savings, the most important may be the lost opportunity of capturing gains from the market. The general trend of asset values, on a year over year basis, is around 8-10% per year. If your money isn’t invested during the time it’s out on a loan, then you will miss this growth in your assets.
You will also miss out on compound growth, by not staying invested. Consider the following scenario: If $1000 grows by 10% in one year, you will have $1100 by the end of that year. The next year if the market grows by 10% again, then you will have $1210 by the end of the year, even if you contribute nothing more, because your assets are growing not based on $1000 but based on $1100.
If you combine that with 1% to 3% in annual dividends that are often provided to stockholders, you can start to understand what kind of opportunity you would be missing out on over 5 to 10 years if your money is not invested.
People who tend to borrow against their 401k are also likely to cut back on their contributions during this time, which can double the lost compounding opportunities. They will no longer be actively growing their 401k, and they may also miss out on employer contributions to the 401k, which is essentially “free money” from your employer.
Many employers will match dollar for dollar contributions (capped at a certain percentage) to a retirement account. That means your money will automatically double as soon as you invest it. There is no better return to be found in the marketplace!
There are also significant tax costs that you should consider with a 401k loan. The contributions made to your account were done with pre-tax dollars, however when you pay back the loan it will have to be done with post-tax dollars. You will have to use more money, in order to return the same amount of contribution, due to taxation.
When you consider the fact that any money withdrawn from the 401k in future retirement is taxed as well, then all of the money that you borrow from the account will be double taxed, and you lose a lot of the tax advantage from the retirement contributions.
On top of all these tax costs, you will also have to pay the interest on the loan as well. While not a penalty or tax, it will contribute to the total cost of the loan that you have to pay back.
Job Change Risk
An additional risk to consider is what happens if you leave your current job. In most cases, if you terminate your employment with your current employer, either voluntarily or involuntarily, you are required to pay back the loan in full within 60 days. If you fail to do so, it’s likely that you will incur some kind of penalty, or have the loan categorized as an early distribution which comes with its own penalties and taxes.
Should I ever take a 401k loan?
There are some scenarios where it might make sense to take a loan against your 401k, but they would only be in extreme circumstances such paying back taxes to the IRS or to avoid bankruptcy. However, you should consider that there may be other types of loans that have better terms and less repercussions for your retirement future. Make sure to compare the rates you can get on other types of loans, such as a home equity line of credit. For people with solid credit, that will likely be a better option than borrowing from a 401k.
Trust Point Can Help you Manage Your Retirement Investments!
Do you need guidance on managing your retirement “nest egg”? It’s important that you understand the risks of financial decisions such as taking a 401k loan. A Trust Point financial professional can help you work through your options and make the best decision for your future. Contact us today to start getting the guidance you need.