Is a 401(k) Loan Worth It?

If you have savings in a 401(k) and a major expense to contend with, you might have considered taking a loan from your 401(k). After all, it’s your money, right?

In some cases, borrowing against your savings can be a prudent strategy – especially if you have the cash flow to promptly pay back the loan. But in other cases, borrowing against your 401(k) can turn a short-term cash crunch into a serious problem.

Here’s what you need to know before making a decision.

What’s a 401(k) loan?

 You may be able to take a loan from your 401(k) account if your employer has permitted such actions in the plan document. This loan isn’t taxable, like a regular distribution would be, provided you meet the following requirements:

  • You borrow up to 50% of your vested account balance, up to a maximum of $50,000 (less if you’ve already borrowed against your account in the last year)
  • The loan is repaid within 5 years (unless used to buy your primary home)
  • You make largely level payments over the life of the loan
  • Payments occur at least quarterly

Your plan document might have unique rules or restrictions, so it’s important to get an understanding of the rules for your specific 401(k) plan before making any decisions.

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The benefits and costs of borrowing

 Having the ability to essentially borrow from yourself can be useful. You have more flexibility in repayment, and you can, within certain bounds, structure your payments as you see fit. This can be more advantageous than taking a personal loan or borrowing money on a credit card.

That said, there are risks. They fall largely within 3 categories:

  • Risks specific to 401(k) loans
  • The long-term growth effects
  • The cost/benefit trade-off of borrowing

401(k) loan risks

 It’s important to understand that these loans operate under their own specific terms and conditions. One of the terms that often surprises people is that if you lose or leave your job your loan will come due – in full – immediately.

In other words, if there is any chance of you losing or leaving your job during the loan period, it’s important to have a back-up plan in place for how you’ll pay the remaining balance. If you can’t do so, you’ll be liable for possible taxes and penalty fees.

That’s because any portion of your loan not paid back becomes a taxable distribution from your retirement plan. You’ll pay income taxes on the amount in question – and if it’s a lot it can throw you into a higher tax bracket – and if you’re under the age of 59 ½ you’ll also pay a 10% early distribution penalty.

Finally, keep in mind that you may need to pay other fees as part of the loan process.

All this together means that the potential cost of your loan could be far higher than it seems!

Long-term risks

 Another important risk to keep in mind is the potential for lost growth over the long-run.

That’s because any money you remove from your investments is losing the opportunity to appreciate in value – and if markets rise by the time you pay your loan off, you’ll need to “buy back” your investments at a higher price. This isn’t just a fair-weather problem: in fact, it can be even more pronounced in market downturns.

Over the course of a few relatively stable years, this might not have much of an impact, but if you compound that potential for lost growth over decades it can make a surprising dent in your savings! If you stop making contributions to your 401(k) in order to pay your loan back, this can become even more costly.

Of course, estimating the exact amount you lose isn’t always simple – especially since no one has a crystal ball saying what the markets will do next. But do a back-of-the-envelope calculation and just keep this risk in mind: it is an important hidden cost that is all too easy to overlook.

Borrowing risks

 Taking a loan from your 401(k) carries some of the same potential risk factors that any other loan would: namely, is it really worth it?

You can and should run the numbers in a few areas to make that determination:

  • What the worst-case scenario costs would be – that is, if you don’t pay the loan back at all or if it comes due after a job loss or job change
  • The possible costs of smaller mistakes and late- or non-payment of part of the loan
  • Long-term growth losses: if your account is growing at a certain average rate, what amount of money could you lose before retirement if you cash out instead? This calculation is shocking to many people, as it exemplifies in clear dollars and cents the impact of compound growth.

Weigh these considerations up against other possible sources of financing – or the use of other savings. Your own personal decision will depend largely on the amount you’re borrowing, the risk factors you face at work and financially, your cash flow, and of course the relative costs of other options.

So what do you do?

 As you’ve probably noticed, we don’t think this is a decision to be taken lightly.

If you’re not sure how to assess your options, consider speaking to a qualified financial advisor. Even a single conversation can get you started in outlining some of the key considerations and assessing your own risks. That, in turn, can help you avoid a costly mistake.

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We can discuss this topic and more at a complimentary appointment. As a bay area retirement planning coaches, we can give you a review and make suggestions based on your retirement objectives.

Important Disclosures

The opinions voiced in this article are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by United Planners.

To determine which investments may be appropriate for you, consult with your financial professional. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk. Neither diversification nor asset allocation can ensure a profit or prevention of loss in times of declining values. United Planners does not render tax advice.

Securities and advisory services offered through United Planners Financial Services, member FINRA, SIPC. Pasquale Vitucci, CA Insurance Lic. # 0758212, is an Endorsed Agent of Vitucci & Associates Insurance Services CA Insurance Lic. # 0I06319. Vitucci & Associates Insurance Services and United Planners are separate and unrelated companies.
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Further Reading

401(k) distribution rules: https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules

401(k) loans as distributions: https://www.irs.gov/publications/p575#en_US_2017_publink1000226839

The risks of 401(k) loans: https://money.cnn.com/2017/08/14/retirement/401k-loan/index.html