Do you want to borrow from a 401(k)? It’s probably not a good idea because your 401(k) is meant for your retirement and not for current consumption. Some people are thinking of borrowing from a 401(k) to buy a home in this strong housing market. I also don’t think that’s a good idea.
The 401(k) is a pre-tax retirement savings account that has replaced the traditional pension for the majority of American workers. Therefore, it is important to not borrow from your 401(k). Otherwise, you might not have enough money in retirement.
Once you combine a 401(k) with Social Security and after-tax savings and investments, you should be good to go in retirement. However, sometimes you might run into a liquidity crunch and want to borrow from your 401(k).
My general recommendation is to never borrow from your 401(k). Instead, let it compound untouched over the long term. If you need money, sell after-tax investments or take on a side hustle to earn more money instead. Resist the urge!
That said, according to the Employee Benefit Research Institute, 18% of 401(k) plan participants have outstanding loan balances. Here’s how to borrow from your precious 401(k).
How To Borrow From A 401(k)
A 401(k) loan is an asset-based loan you take against your employer-sponsored 401(k) plan. You’re really borrowing money from yourself with interest.
Under IRS regulations, you can borrow up to the lesser of:
The greater of $10,000 or 50% of your vested account balance, or $50,000.
In either case, the allowable percentages pertain to your vested balance and not your total balance. Any employer contributions that are not considered vested are not eligible to be borrowed through a 401(k) loan. Your 401(k) balance generally vests after one year of full employment after your employer contributes any matching or profit sharing.
Example: That means if you have $100,000 in your 401(k) plan and $10,000 is unvested employer contributions, the net value of your plan is $90,000. You can borrow 50% of the net value, which translates to $45,000.
When you take a 401(k) loan, it’s set up like any other type of loan. It’s for a specific amount of money and repayable over a definite term, usually not more than five years. Interest will be charged on the amount of the outstanding loan balance.
What makes 401(k) loans especially convenient is that repayment is payroll deducted. You don’t have to write a monthly check, and you don’t even have to set up an online automatic debit from your bank account. Your employer will simply add another line-item deduction from your regular paycheck. The deduction will continue until the loan is paid in full.
Check With Your Employer First Before Borrowing
The IRS allows many provisions with 401(k) plans, but the employer doesn’t necessarily need to offer them. 401(k) loans fall into this category. So don’t assume an employer offers them just because they provide a 401(k) plan.
Other provisions include employer matching contributions and certain types of investments. While an employer can offer these provisions, they’re not required to do so. It doesn’t matter if they were offered by a previous employer. Each employer has the latitude to include or exclude certain provisions as they deem necessary.
What Are The 401(k) Loan Costs
There are three costs associated with 401(k) loans. This is obviously a negative for borrowing from a 401(k).
Administrative Fees. There is usually some sort of fee charged by the plan administrator to create the loan. It might be something like $100. If the loan amount is $10,000, you are paying a 1% origination fee for the privilege of getting the loan. The fee is usually withdrawn from your plan balance. This causes a slight but permanent reduction in the plan’s value.
Interest Expense. 401(k) loans typically charge interest on the amount borrowed. The rate is usually one or two points above the prime rate, which is currently 4.75%. That would produce a rate of between 5.75% and 6.75%.That rate is lower than what you will pay for a loan from just about any other source. And on top of that, since the interest goes to your plan, you’re basically paying interest to yourself. That seems like a good deal, at least until you consider the next 401(k) loan cost.
Opportunity Cost. While the loan is outstanding and you’re making interest payments on the amount borrowed, you’re not receiving investment income on the unpaid balance. Even though the outstanding balance is receiving interest, you are the one paying it. You are still losing the “free” income from being invested.For that reason, a 401(k) loan is not a good deal from an investment standpoint.
Advantages Of Taking Out A 401(k) Loan
If you borrow from a 401(k), there are some advantages. These are the main ones.
No need to qualify with a lender. With virtually every other type of loan, you must qualify based on your income, employment stability, credit history and credit score, and sometimes certain assets. It took me 4 months to try and qualify for a mortgage loan one year, and I still got rejected. With 401(k) loans, you qualify based just on the fact that you’re employed by the plan sponsor and you have sufficient equity in your plan to support the loan requested.
Ease of repayment. Repayment is handled strictly through payroll deduction. You don’t need to write a check and mail it to a third-party servicer or set up an automatic draft from your bank account.
Paying yourself interest. Even if the interest rate is high, at least you’re paying yourself back.
No taxes or early withdrawal penalties. If you were to liquidate the needed funds from an IRA or an old 401(k) plan, you would have to pay taxes on the amount withdrawn. As well, if you’re under 59½, you would have to pay a 10% early withdrawal penalty. But you can borrow money from a 401(k) plan without any tax consequences whatsoever.
The Disadvantages of 401(k) Loans
You’re hurting your retirement future. By taking money out of your 401(k), you are hurting your retirement future by not letting your investments compound. Not only are you not letting your investments compound, you are spending money, a double whammy.
You develop bad long term financial habits. If you cannot resist the urge to borrow from your 401(k), then you will start relying on your 401(k) as a crutch whenever there is some type of “emergency.”
You might be subject to the early distribution trap. Should you leave your employer before the loan is repaid, the entire outstanding balance will be due and payable. If not paid, it will be considered an early distribution from your plan. It will then be subject to ordinary income tax, as well as a 10% early withdrawal penalty if you’re under 59½ years old.
The employer will generally allow you up to 60 days to repay the loan balance. After that, it will be considered a distribution, and they will issue Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. You’ll be required to report the amount showing on the form on your income tax return. What a pain!
Average 401(k) Balance By Age
To get you motivated to not take out a 401(k) loan and to continue building your 401(k) balance, here is a guideline for how much you should have in your 401(k) by age. The guideline is for those who want to achieve financial freedom before the age of 60 and not slave away forever.
As you can see from the chart, everybody should be a 401(k) millionaire by the time they turn 60. With the maximum contribution amount at $18,500 as of 2018, there is no reason why everybody shouldn’t have seven figures in their 401(k) by the time they retire.
Borrow Wisely From Your 401(k)
If you must borrow from your 401(k), make sure your employment is stable and make sure you pay off your loan in less than five years. Please do not get in the habit of borrowing from your 401(k). The more you can maximize contribution and leave it alone, the happier you will be 10, 20, 30 years from now.
I promise all of you that achieving financial freedom is worth it.
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About the Author: Sam began investing his own money ever since he opened an online brokerage account in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at two of the leading financial service firms in the world. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate.
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