401(k) Loans: The Option of Last Resort

If you need funds to cover an unexpected expense, taking a loan from your 401(k) account may sound like an appealing solution. Although many retirement plans offer these loans, borrowing from your 401(k) comes with some unique risks and costs that can seriously compromise your long-term retirement savings. If you’re considering a 401(k) loan, it’s critical to weigh the pros and cons carefully.

401(k) loan basics

Taking a loan from your 401(k) is essentially borrowing from your future to finance other goals today. To avoid dipping into your retirement account, it’s wise to have enough cash saved in an emergency fund to cover at least three months of living expenses. (Ideally, your emergency fund should cover six months of expenses.) If you don’t have any cash reserves, it makes sense to explore other alternatives, such as credit cards or bank lines of credit, before tapping into your retirement funds.

But if borrowing from your 401(k) is your only option in a financial emergency, such as paying medical bills, it’s important to understand how these loans work:

  • You can borrow as much as half of your vested account balance, up to a maximum of $50,000, assuming you have no outstanding loans in the previous 12 months.
  • If you’ve taken another 401(k) loan in the last 12-month period, you will be limited to 50 percent of your vested account balance, or $50,000, minus the outstanding loan balance in the preceding 12-month period, whichever is less.
  • Most loans must be paid back over a five-year period.
  • If you use the loan to purchase a primary residence, the term is usually 10 to 15 years.

Pros and cons of 401(k) loans

401(k) loans do have some attractive features that may make them a viable option, depending on your situation. For example:

  • They’re relatively cheap and easy to obtain. (You’re essentially borrowing from yourself and paying yourself back with interest.)
  • The interest rate is determined by the plan but is usually based on the prime rate, plus 1 or 2 percent.
  • There are no restrictions on the amount you’re eligible to borrow (within the maximum loan limit) or what you may borrow the money for.
  • There are no credit checks, and paperwork is usually minimal.
  • Payments are typically deducted from your payroll checks automatically.
  • You can choose which plan investments to sell in order to make cash available for your loan.

Unfortunately, the downsides of 401(k) loans often outweigh these advantages:

  • If you default on your loan, the unpaid portion will be treated as an age-based distribution, subject to ordinary income tax, as well as a 10-percent early withdrawal penalty for those under age 59½.
  • If you lose your job or leave the company, your plan may require full repayment of the loan within 60 days. If you cannot repay the loan, it will be considered defaulted.
  • There’s no flexibility to change the loan repayment terms.
  • You pay interest on the loan with after-tax dollars, and that money will be taxed again when you begin taking distributions in retirement.
  • In order to make your loan payments, you will likely reduce the amount you contribute to your 401(k), diminishing your long-term retirement savings.
  • By pulling money out of your account, you reduce the valuable benefits of compounding interest.

A note on taxes

As mentioned above, interest payments on a 401(k) loan are not tax-deductible. Unlike pretax 401(k) deferrals, which reduce your taxable income, the interest you owe on your plan loan is paid back to your 401(k) with after-tax dollars. Since you will be taxed again on that money when you withdraw it in retirement, it is technically taxed twice. Even though this cost may be relatively minor, it’s another factor to consider.

A plan of last resort

Before you tap into your 401(k), be sure to ask yourself the following questions:

  • Are you facing a true financial emergency?
  • Have you explored all of your available credit options, including home equity loans?
  • Do you plan to stay at your job for the next several years and feel that your employment is secure?
  • Are you prepared to take responsibility for how much you borrow and pay back, without a credit check or the oversight of a bank?
  • Have you considered the potential impact on your tax liability if you borrow more than you can afford and default on your loan payments?

Over time, borrowing from your 401(k) can disrupt your financial well-being in a variety of ways. All too often, people use 401(k) accounts as a personal slush fund while disregarding the long-term consequences. Although taking out a 401(k) loan may make sense in some circumstances, it’s essential to consider all of your options to ensure that you’re not shortchanging your future.

 

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

 

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Joelle Spear is a financial advisor located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. She offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. She can be reached at 508.598.1082 or jspear@canbyfinancial.com

 

© 2015 Commonwealth Financial Network®