Most of us have been in a situation where we needed to get a loan and the question of where to go to get it was the million dollar question. It is hard to believe, according to Fidelity’s analysis of 13 million investors, one in five people, or 22.5% of Fidelity’s 401(k) investors, borrow against their retirement savings, up from 18.7% in 2000. More than 2 million investors have outstanding loans, and nearly 1 million took out loans in the past year. These numbers may say to you that maybe it is ok to borrow from my 401K! Before you come to that conclusion let’s take a look at some of the things you should know before doing so.
It is important to understand that this is a loan and it needs to be paid back in a timely fashion. A borrower can typically borrow no more than $50,000 or one half of the amount in his/her retirement plan. The loan payback period starts immediately after the loan has been made and it typically is done through payroll deductions on a monthly basis. This loan must be paid back in 5 years or less under normal circumstances (there are some exceptions to this rule, such as buying a home). The interest rate typically charged to the borrower is the prime rate plus 1%. Today the prime rate is around 3.25%. Now one could argue that the borrower is actually paying himself/herself interest on the loan and one could argue that this is a good thing. On the other hand, the borrower has lost the power of compounding (investment growth) with the dollars that have been taken from the retirement account. Remember, the investment dollars are growing tax deferred, which means that there are no taxes paid until the dollars are distributed to the borrower. It is also very important to understand that the dollars that are being used to pay back this loan are post-tax dollars and the dollars you invested in this retirement plan were pre-tax dollars. As a simple example, let’s assume a $200 repayment will reduce your take home pay by $200, but a $200 contribution to your retirement plan may only decrease your take home pay to $140 because you are using pre-tax dollars to fund this contribution.
What happens if you cease working for your employer and you still have this loan to pay off? Be careful on this issue! If you are unable to pay off the entire loan within 60 days of leaving your current employer, and most can’t, the loan now falls into the category of a distribution and it is likely that it will be subject to federal and state income tax along with an early distribution penalty of 10%. The 10% penalty is for taking distributions prior to turning 59 ½ years old. If the borrower is over 59 ½, this penalty is not part of the equation. There are, in rare cases, some plans that have taken this situation into account and allow the ex-employee to pay off this loan with the use of a coupon book, which will allow the borrower to continue to make payments on the loan under the original terms of paying off the loan in 5 years or less! Don’t count on this being the case in your situation.
There are, however, some acceptable reasons to borrow from your 401K and I will share a few of them with you with the understanding that in MOST cases we advise our clients that this is truly the last resort to get dollars. Here is a quick list: 1. Medical emergency 2. Purchase of a home (down payment) 3. Finance a business (cost of capital is cheap) and there are no credit check requirements. 4. Enhancing your education (acquiring educational credentials needed to keep your job).
It is very important to understand the ramifications of borrowing from your 401K and hopefully this brief overview will make you think twice before doing so.
All comments and suggestions are welcome.