Cut out the middleman and pay yourself instead — but look before you leap.
Most financial planners say borrowing from your 401(k) is a bad idea, period. I disagree.
Borrowing from your 401(k) plan can be a smart move if you need the money for a serious purpose, such as a down payment or to pay high-interest debt. But you must be sure you can pay off the loan.
A loan can make sense if you have an expensive emergency, such as flood damage from Hurricane Harvey and can be a better move than running up credit-card debt.
Borrowing from your 401(k) or other retirement plan isn’t like other loans as it doesn’t involve a lender. Instead, you can access your account without paying tax or penalties as long as you pay back the loan on time.
Interest doesn’t vanish into a lender’s pocket. You pay yourself. It’s more like buying a bond. You may even achieve a higher yield than you would by investing in bonds in your account.
Typically, you’re allowed to borrow up to 50% of your account balance or $50,000, whichever is less. Regulations specify a 5-year repayment schedule, but you have the opportunity to pay off the loan sooner.
Loans used to purchase a primary residence may be paid back over a longer time, typically up to 15 years. Payments usually come directly out of your paycheck on an after-tax basis. Your plan determines the interest rate, based on prevailing interest rates.
Consider your job security before taking a loan. If you still owe money when you leave your job, you will need to repay the balance in full within a short grace period, usually 60—90 days.
If you fail to repay the loan on time, it will be treated as an early distribution — meaning it will become taxable and subject to a 10% early withdrawal penalty if you are under the age of 59 ½.
You will owe a substantial sum not to yourself, but to the Internal Revenue Service.
Anyone should consider the other drawbacks before taking a loan.
First, there is the opportunity cost. If you’re mainly invested in stocks, the average annual expected return hovers around 10% — more than the typical interest rate on borrowing from your 401(k), currently around 3%.
The opportunity-cost objection assumes the stock market will always rise. That’s true over the long term, but you can actually increase your wealth if the market happens to dip while your 401(k) loan is outstanding. The objection to borrowing on the grounds of missing potential gains ignores the potential for losses over short periods.
Another drawback, is when borrowing from a traditional 401(k), you withdraw pre-tax money and repay it with after-tax money.
So, before taking a 401(k) loan, look to other funding sources first. If you’re a homeowner, you might consider a low-rate tax-deductible home equity line of credit. Other sources might be an intrafamily loan or a loan from friends.
When It Makes Sense
But absent other good choices, a loan can be the best solution. For instance, it can make sense for people who are retirement-fund rich. That’s someone with a good 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 6-figure student loan debt (A profit-sharing retirement plan is different from a 401(k), but the loan worked the same way.)
I used the money to pay down a significant portion of the principal, which shortened the term of this loan as I continued to make the normal monthly payments. Instead of paying a high rate to the lenders, I paid myself at a lower rate.
This strategy only works if you have the cash flow to support both loan payments, but if you can handle it, it can save you money because you’ll pay off your debt faster.
Another good reason is to help finance the purchase of a home, especially a first home. For example, the 1-bedroom apartment that was fine for a young married couple may abruptly become unworkable when the couple gives birth to twins. Taking out a 401(k) loan is probably better than waiting years while you save up for a down payment.
Retiring high-interest credit card debt is another possible use for a 401(k) loan.
If you accumulated this debt due to an unusual event, such as a major medical expense, it can make sense to pay it off once with a 401(k) loan. But if your credit card debt is the result of profligate spending, ask yourself if you’ve truly changed your ways before you even think about touching your retirement account.
Similarly, if you’re hit with a major unexpected 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.
While borrowing from your 401(k) shouldn’t be your first resort, it can be a good move.
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.
Eric Meermann, Certified Financial Planner (CFP), Enrolled Agent (EA), is vice president of Palisades Hudson Financial Group in Stamford, Connecticut. Palisades Hudson Financial Group is a fee-only financial planning firm and investment manager based Fort Lauderdale, Florida, with more than $1.3 billion under management. It offers financial planning, wealth management, and tax services. Its Entertainment and Sports Team serves entertainers and professional athletes. Branch offices are in Stamford, Connecticut; Atlanta, Georgia; Portland, Oregon; and Austin, Texas.The firm’s monthly newsletter covering financial planning, taxes and investing is online at www.palisadeshudson.com/insights/sentinel. Sign up to receive articles by email at www.palisadeshudson.com/get-sentinel.Social media: Twitter; LinkedIn; Facebook; Instagram.