If you have a 401(k) plan and you are funding it, you are ahead of the game.
According to data from the U.S. Census Bureau released in early 2017, only about a third of American workers are saving anything at all in a tax-deferred retirement plan. Under these circumstances, it is easy to understand why most financial planners would encourage you to leave your retirement nest egg alone. In most cases, your retirement account does you the most good when you leave it to grow.
Sometimes, however, the money in your retirement account can do more good in the present than in the future. That is why 401(k)s and some other retirement plans build in a mechanism for borrowing without triggering the tax consequences of an early distribution. While you should never raid your 401(k) for a new flat-screen TV or a vacation, under certain circumstances borrowing from your retirement plan can serve as a responsible financial planning solution.
Can You Borrow From Your 401(k)?
First, before deciding whether you should borrow from your retirement account, you should make sure you understand whether you can do so. While the strategy is often called a “401(k) loan,” borrowing from your retirement account doesn’t involve a lender and it may not even involve a credit evaluation. Instead, you can access part of your retirement account without paying tax or penalties as long as you pay it back within certain parameters.
Most of the time, you are allowed to borrow up to 50 percent of your account balance or $50,000, whichever is less. Regulations specify a five-year repayment schedule, though typically there is no penalty for repaying the loan faster. An exception: Loans used to purchase a primary residence may be paid back over a longer time. Payments usually come directly out of your paycheck on an after-tax basis. The plan determines the interest rate, based on prevailing interest rates in the market.
It is key to remember, though, that this is “interest” you are paying to your own account, not to a third party such as a bank. In this sense, the interest isn’t a cost that just vanishes into a lender’s pocket. Instead, you can think of it more like a bond. Depending on the loan’s interest rate, you may even achieve a better potential yield than investing the same portion of your retirement account in fixed-income investments.
You should seriously consider your job security when deciding whether to borrow from your 401(k) plan. If you leave your job before the repayment period ends, you will need to repay the balance in full within a short grace period, usually 60 to 90 days. Since most people borrowing from a retirement account do so to meet a short-term need that they can’t pay another way, it is unfortunately likely that paying back the lump sum will be challenging, if it is possible at all. If you fail to repay the loan within the grace period, it will be treated as an early distribution – meaning it will become taxable and subject to a 10 percent early withdrawal penalty if you are under age 59 ½. At this point, you will owe a substantial sum not to yourself, but to the Internal Revenue Service.
Should You Borrow From Your 401(k)?
Many financial planners dogmatically insist that no one should ever borrow from their retirement plans for any reason whatsoever. “Everything else can be financed, except retirement,” the theory goes. Why this nearly religious insistence on leaving your retirement accounts alone?
First, many Americans have little or no retirement savings at all. It is unsurprising, in that sense, that financial planners want those who have savings to preserve them. The potential downsides of job loss or failing to pay back the loan I mentioned above are serious, of course. But on the assumption that you will pay back the loan, and more, the question becomes why short-term borrowing should make a difference.
The standard answer is opportunity cost – that is, the ability to leave the funds invested in a diversified, equity-based portfolio. For retirement savers whose accounts are mainly invested in stocks, the average annual expected return hovers around 10 percent – more than the typical interest rate on borrowing from your 401(k), which right now might come out around 3 percent. In this sense, the argument against borrowing is that you will lose out on the compound growth tax-deferred accounts like 401(k)s provide.
That said, tax deferral isn’t always all it is cracked up to be, especially if your tax bracket is likely to stay substantially the same in retirement. For instance, say Sarah has $50,000 saved in a traditional 401(k); her current tax rate is 40 percent. If she took it all out today and paid tax – assuming she is old enough to avoid the early withdrawal penalty – she would be left with $30,000. If she left it in the account to grow for an additional 10 years, Sarah might see the total grow to $100,000. But she would also pay $40,000 in tax, rather than $20,000. The tax liability grows right along with the account balance. Depending on how tax rates and growth play out, you can see how losing out on a few years of compound interest in tax deferred accounts may or may not end up mattering substantially.
Incidentally, this is why you should never borrow from a Roth 401(k). A Roth account is funded with after-tax dollars, but the account grows tax-free. That means, in the example above, Sarah gets to withdraw the full $100,000 if she waits an extra decade.
The opportunity cost objection also assumes the stock market will always rise. While Palisades Hudson does agree this is true over the long term, it is worth noting that you can actually increase your wealth if the market happens to dip while your 401(k) loan is outstanding. We never encourage market timing, so this is not to suggest you take out a loan specifically in an attempt to work around a down market. But the objection to borrowing purely on the grounds of missing potential gains ignores the potential for losses over short periods.
The other major objection many financial professionals raise to borrowing against a 401(k) is that the strategy is not tax efficient. When you borrow from a traditional 401(k), you withdraw pretax money and repay it with after-tax money instead. While this is true, and not ideal, the reality is that, for people in a position where they need to consider a 401(k) loan, this factor is likely not their biggest concern.
That said, for the reasons above, it is worth considering other funding sources first if they are available to you. If you are already a homeowner, for instance, you might consider a low-rate home equity line of credit, or HELOC, which may be a better way to cover a short-term need. Other solutions might be an intrafamily loan or a loan from friends, if practical. Ideally, you would have an emergency fund in a taxable account to cover the types of situations that might prompt you to borrow from your 401(k) in the first place.
When Borrowing Makes Sense
With all of this in mind, borrowing from a retirement plan can still be a sound financial planning strategy under the right circumstances. For instance, it may make sense for people who are “retirement-fund rich:” individuals with a healthy salary, little taxable money, significant retirement savings and big debt.
That description fit me several years ago, so I used a loan from my profit-sharing plan to jump-start my efforts to pay down my six-figure student loan debt. (A profit-sharing plan is different from a 401(k) in some ways, but for this example, they are functionally similar.) Borrowing a lump sum from my retirement plan allowed me to pay down a significant portion of the principal, which shortened the term of my loan as I continued to make the standard monthly payments too. This strategy only works if you have the monthly cash flow to support both loan payments, but if you can responsibly budget it, the strategy can save you money as well as help you pay off debt faster. Because of the power of compound interest, even modest extra payments to reduce the loans’ principal have large effects over the term of a 30-year loan.
Paying down student loan debt is an excellent use for borrowed retirement funds, especially private loans with a relatively high interest rate. As long as you make regular payments and don’t go back to school, the loans’ principal outstanding only goes down. Once the loan is done, it is done forever.
Another relatively common reason to borrow from your retirement account is to help finance the purchase of a home, especially a first home. This approach may make sense if you fear the effect of rising interest rates, home prices or both. A 401(k) loan can also help when your living situation is harming your quality of life to the extent you need to change your circumstances as soon as possible. For example, the one-bedroom condo that was perfectly good for a young married couple may abruptly become unworkable when the couple gives birth to twins. Taking a lump sum out of a 401(k) would not be the optimal choice, but waiting years to save up for a down payment may not be worth the discomfort and stress.
High-interest credit card debt is another common target for 401(k) loans. In this instance, it is important to be honest with yourself. If you accumulated this debt due to financial hardships that are unlikely to recur, such as the unexpected loss of a job or a major medical expense, it can make a lot of sense to pay it off in one shot with a 401(k) loan and pay yourself back at a lower interest rate. If, on the other hand, your credit card debt is the result of profligate spending, you should make the tough choices necessary to make sure you have your habits in hand before you even think about touching your retirement accounts.
Similarly, if you are hit with a major unexpected yet necessary expense, the ideal scenario would be to cover it with an emergency fund. If your savings cannot cover the cost, however, a 401(k) loan could prevent you from incurring high-interest credit card debt instead.
Borrowing from your 401(k) is not a decision to make lightly. But it can be a useful tool for achieving certain financial objectives. As with any major financial decision, you will need to balance your goals with the potential risks and decide whether the approach is right for you.