If you’re facing a financial emergency or you’re in a cash crunch, you may consider borrowing from your 401(k), 403(b), or other employer-sponsored retirement plan.
When you take a loan from your 401(k), you are borrowing from yourself rather than a bank or other commercial lender. The interest rate is usually reasonable, often just a percentage point or two above the current prime rate. And because you’re paying yourself back, the interest you owe ends up in your account.
In addition, you don’t have to be approved or go through a credit check to borrow from your 401(k). In many cases you don’t have to explain or justify to anyone why you need the money. Plus, the loans are usually processed in a matter of days.
RISKS OF 401(k) BORROWING
But 401(k) loans aren’t without risks. To start with, you lose out on potential growth in your retirement account. That’s because the money you take out reduces the principal on which earnings accumulate. In fact, a study by the Center for American Progress, a Washington policy institute, suggests that the average worker who takes a $5,000 401(k) loan reduces his or her future retirement savings by up to 22%.
And because you have to make payments towards the loan, you may be tempted to reduce the size of your regular 401(k) contribution, or stop making contributions altogether. This further erodes your account’s potential long-term value. In addition, unlike a home equity loan or line of credit, the interest on a 401(k) loan isn’t tax deductible even if you use the loan to buy a home.
Not only that, but you’ll pay income tax twice on the amount you borrow: once because the money that’s deducted from your paycheck to repay the loan is after-tax income, and a second time when you make withdrawals from your account during retirement.
A LAST RESORT
Plan sponsors aren’t required to permit 401(k) loans, but many do. According to the Profit Sharing/401(k) Council of America, about 88% of plans allow participants to borrow from their retirement accounts. However, some plans limit the number of loans you can have outstanding at any one time.
Federal law caps the amount you can borrow at 50% of your vested account balance or $50,000, whichever is less. And because 401(k) loans can be costly to administer, some programs may impose a loan floor, or minimum amount you must borrow. For example, your employer may set a minimum of $1,000 for a 401(k) loan.
In addition, you may have to pay a fee to cover the administrative costs of arranging the loan. Each plan sets its own rules, within federal guidelines, so you’ll need to check with your plan administrator.
THE BIG PAYBACK
If you borrow from your 401(k), you’ll need to sign a loan agreement, just as you would if you were borrowing from another source. There’s very little flexibility to renegotiate repayment if your situation changes, so before you borrow you should be sure you’ll be able to meet the loan terms.
You usually have up to five years to repay the loan with regular deductions from your paycheck. And, in most cases, you begin to repay almost immediately after receiving a check for the amount you borrowed. If you’re borrowing to purchase a primary residence, you may have as long as 25 years to repay the loan, although this exception doesn’t apply if you’re buying a vacation home. In most cases, you can pay the loan off early if you want to without penalty.
However, if you leave your job, you’ll probably have to repay your entire loan balance within 30 to 90 days of your departure. If you can’t repay by the deadline, it’s considered a default, and you owe tax on the outstanding balance, plus a 10% early withdrawal penalty if you’re younger than 59½. These rules apply even if you’ve been laid off and you’re unemployed.
It’s extremely unusual to be able to transfer a loan to a new employer’s plan, though it’s probably worth asking about if you’ve been recruited to a new position. You may also be able to arrange a personal loan, called a floater loan, or an advance against your salary or bonus to settle your debt.
Some plans require you to get your spouse’s approval before you borrow from your 401(k). Consent is essential in any plan that requires a joint or survivor lifetime payout. In that case, retirement income is paid over two lifetimes, yours and your spouse’s. Other types of plans may require spousal approval as well.
If you’re separating or getting divorced, spousal consent for a loan can become a serious point of controversy. Your spouse might have a right to a portion of your 401(k) assets, or you might have a similar claim on your spouse’s assets. If one of you borrows from your own account, and then changes jobs and doesn’t repay, the other spouse’s rightful share could be affected. You might want to consult an attorney if you anticipate a potential problem.
IN YOUR BEST INTEREST
Whether your retirement savings take a big or small hit depends a lot on the market environment when you borrow. For instance, if you take a loan just before or during a period of stock market growth, you’re missing out on potential earnings on the money that’s no longer in your account. On the other hand, if you borrow right before a sustained downturn or when the markets are flat, the interest you’re paying yourself could even give your account a boost.