Regarding retirement funds, there is good news, bad news, and more bad news. It’s encouraging that most working Americans may participate in a 401(k) or other workplace retirement plan (k). According to a study done in 2018 by Stanford University, around 50% of American households take part in a corporate retirement plan such as a 401(k) (k). Ninety percent or so of workers in each age bracket who are eligible for these programs actually enroll.
Most people in the United States do not have enough money saved for retirement. In 2020, the average employee contribution to a company’s retirement plan will be only $104,400, according to research by Fidelity. And it won’t even bring you close to where you need to be to retire comfortably, even if you have decades to go.
Another piece of bad news is that many Americans are substantially depleting their retirement savings by borrowing against their 401(k)s. According to research conducted by Fidelity, about 20% of all people who have ever enrolled in a 401(k) plan have borrowed money from it. 1.6% of all Americans borrowed from their 401(k)s in the second quarter of 2020, with the average loan amount being $12,600.
If you’re in a tight spot financially, you might be tempted to take out a loan on your 401(k). Interest rates on payday loans and credit card debt carryover are much greater than with this solution. However, there are significant risks involved with borrowing from your 401(k) that might endanger your financial security.
401(k) Loans and How They Work
Until you reach retirement age, you likely won’t be able to access the funds you’ve contributed to a 401(k) plan. If you remove the funds before then, it is considered an early distribution, and you will be subject to a 10% penalty on top of whatever taxes you owe.
If you have $50,000 in your plan and withdraw $5,000, your balance will decrease to $45,000 and you’ll have to pay a $500 penalty. (As we’ll see later, this fine was suspended for 2020 thanks to the CARES Act, a coronavirus relief measure introduced during the COVID-19 epidemic. At the start of 2021, the fine will once again be in effect.
You may get around this restriction, though, by taking out a loan on your 401(k) instead of making a direct withdrawal. Your plan’s balance remains at $50,000, but you’ve taken out a loan from yourself for $5,000. If you repay the loan and interest within five years, you’ll avoid paying interest or income tax on the money you borrowed.
401(k) Loan Limits
Although 401(k) loans are not mandated by law, most employers offer this option to their employees. However, there are restrictions on how much you may borrow due to regulations from the IRS.
If you quit your work today, you would be entitled to keep half of your vested account balance, which is the sum of your contributions and your employer’s contributions. 401(k) loans can only go as high as the borrower’s account balance. Even if your vested balance is more than $100,000, you can’t withdraw more than $50,000. If your account is under $20,000, though, you can take out a loan of up to $10,000. These are only the IRS’s guidelines; individual companies are free to establish even more generous policies.
The Internal Revenue Service does not prohibit you from taking out multiple 401(k) loans simultaneously, so long as the sum of all your loans does not exceed the limit. In most cases, however, taking out a second 401(k) loan is only permitted once the previous one has been repaid in full. Some companies restrict 401(k) loans to specific life events, including a major purchase or medical bills.
401(k) Loan Interest
Since you are borrowing your own money from your 401(k), a credit check is not necessary. That’s why it’s one of the most convenient lending options for those with bad credit.
In most cases, regardless of a borrower’s credit history, the interest rate on 401(k) loans is a flat one percentage point over the prime rate, as established by the businesses that manage 401(k) programs.
Contrary to popular belief, this interest does not benefit the lending institution. Any interest you pay on a loan to yourself is simply deposited there. It’s part of what makes 401(k) loans appealing to borrowers, and it may make the risks seem less significant.
Issues with 401(k) Loans
There are many different motivations for borrowing against a 401(k). Borrowing is common because people need money for important life expenses including a down payment, tuition, medical bills, home repairs, taxes, and other forms of high-interest debt.
A 401(k) loan is a convenient method to get the cash you need for any of these reasons. This sort of loan has cheap interest rates and is easy to qualify for because no credit check is performed. And since you are, in effect, borrowing from yourself, it would appear that you can’t go wrong.
The money borrowed from your 401(k) plan, however, will not be interest-free. It’s a gamble that might set you behind in the short term and ruin your retirement fund in the long run.
Also, if you are unable to repay the loan by the due date, you will be subject to a severe penalty that will significantly worsen the already devastating impact on your finances.
Here are six common sense reasons why you shouldn’t take out a loan on your 401(k).
- Paycheck Reduction
A 401(k) loan, like any other loan, must be repaid, and the money to do so comes straight out of your regular paycheck. You may avoid skipping a 401(k) contribution by having money taken automatically from your paycheck. Every paycheck you receive up until you repay the debt will be less.
Regardless of whether or not this is accounted for in your plan, you’ll still need to allocate funds each month to pay back the loan, cutting into your discretionary spending.
This additional cost may make it extremely difficult, if not impossible, to pay your basic living expenses if your financial situation is already precarious. For the best case scenario, you’ll have to cut back even more on discretionary spending like going to the movies or eating at nice restaurants. The worst-case scenario is that you will need to borrow additional money, say, via credit cards, just to keep up with your current financial obligations.
- Retirement Savings Have Been Reduced
Taking out a loan against your 401(k) can delay your retirement savings and cost you more money down the road. There are three ways in which this sort of borrowing might stunt your retirement savings:
- Your Involvement is Decreasingly Important. While paying off debt, many people halt or reduce their 401(k) contributions. In fact, Credit Karma reports that certain 401(k) programs won’t even let you make contributions if you have a loan out. If you take the entire five years to repay your loan, you would lose out on five years’ worth of 401(k) contributions and any earnings those contributions may have generated.
- Your company’s contribution has decreased. When an employee makes a 401(k) contribution, their company often matches that amount. As an instance, your company may offer to double your contributions up to a certain percentage of your annual pay. So, if your annual salary is $50,000 and you put away at least $1,500 into your 401(k), your company will put in another $1,500. In order to pay off a 401(k) loan, you may need to reduce your annual contribution to $0; however, doing so may result in the loss of not just $1,500, but also your employer’s matching $1,500 and any interest that may have accrued on that amount.
- In other words, there is less room for expansion for you. If you take out a $5,000 loan from your 401(k), that’s $5,000 less money you have working for you. The only profit you’ll get on that $5,000 is the interest you pay yourself until you pay it back, and because you’re paying it back with money you don’t have, it’s not really a profit. Furthermore, when interest rates are low, it is likely that you would receive a greater return by investing the money elsewhere in your 401(k), such as in equities. Delaying the repayment of a 401(k) loan will have a negative impact on your retirement savings.
- Fees and Interest
Loans taken out of a 401(k) typically have low interest rates, but they aren’t always the best option. A home equity line of credit (HELOC) from Figure.com may offer a more attractive interest rate if you have decent credit. However, if your credit is poor, a 401(k) loan may offer the best terms available to you.
Interest on a 401(k) loan is never squandered, as it is deposited directly into your account. However, in addition to the interest on the loan itself, you will also have to pay an origination charge of $50 to $100. Additional charges may be incurred for the management and upkeep of your 401(k) loan until it is repaid.
- Extra Taxes
Taxes are higher when you take money out of your 401(k). Typically, 401(k) contributions are made before taxes are taken out. It’s one of the best things about putting money into a 401(k). A 401(k) loan, however, necessitates using after-tax funds to repay the loan, negating any potential tax benefits.
Suppose, for argument’s sake, that you’ve taken out a 401(k) loan of $5,000. (k). To repay that $5,000 in after-tax funds if you’re in the 25% tax bracket, you’d need to make $6,250.
The loan’s interest is also paid out of your pocket after taxes. A 6% interest rate represents an additional $300 in payments, or $375 in income needed to cover them. Even worse, you’ll have to fork up taxes on the same $5,000 all over again when you take it out in retirement. Taking out a loan against your 401(k) means you’ll end up paying taxes on the money borrowed twice.
- Repayment Risks
What happens if you can’t repay the loan in a timely manner is the main concern with 401(k) loans. After five years, the IRS will consider any unpaid loan balance to be an early distribution subject to taxation and a 10% penalty if it is not repaid in full.
Let’s say you borrow $5,000 and pay it back over the course of five years, only to have $4,000 left over. The remaining $1,000 is considered an early withdrawal and will incur taxes and penalties totaling around $350. In 2017, an article was published in the National Tax Journal claiming that about 10% of all 401(k) debtors had defaulted in this method.
Making all of your loan payments on schedule will, in principle, prevent this from happening, but there’s no guarantee you actually will. Your 401(k) loan debt is payable in full if you no longer have access to your 401(k) due to job loss or a job change.
Before the due date of your next federal income tax return, you must do one of two things: either pay off the loan in full or roll over the funds into a new 401(k) plan, or face a penalty (k). If neither option is feasible, an early distribution will be assumed. In the study published in the National Tax Journal, it was found that 86% of borrowers who left their employment while still owing money on their 401(k) loan did not pay it back.
- Dependence on Debt
As a final issue, taking out loans from your 401(k) might become habitual. The majority of 401(k) borrowers, according to a 2013 Fidelity research cited by The New York Times, end up withdrawing money from their accounts once again. Over a 12-year period, the study analyzed data from 180,000.
These individuals had all joined a 401(k) retirement savings program. It was discovered that 65% of them had borrowed from their 401(k)s more than once, 25% had borrowed 3–4 times, and 20% had borrowed at least 5 times.
According to the paper, these debtors aren’t always “dysfunctional.” The majority of these people were in their forties and fifties, a time when they have numerous conflicting financial responsibilities, such as paying for their children’s further education or taking care of their parents. It’s possible that many of them are taking out these loans to help them weather temporary financial storms caused by things like losing their jobs or incurring unexpectedly large medical costs.
However, the reality remains that these borrowers are severely undermining their retirement savings by repeatedly taking out 401(k) loans to cover their living expenses. If a person takes out two 5-year loans, they may wind up with 13.8% less money in retirement compared to someone who doesn’t take out any loans.
If you take out three loans, your retirement savings would decrease by around 19%, and if you take out four loans, your savings will decrease by 23%.
When Should You Consider a 401(k) Loan?
401(k) loans have a number of negative aspects, yet there are still times when they may be preferable to other options. As a last resort, a 401(k) loan might be useful if you need money for:
- Compensation of Tax Obligations. When you owe money to the Internal Revenue Service (IRS), they can claim ownership of your property by filing a tax lien. Having a tax lien on your property might make it difficult, if not impossible, to sell the home or refinance the mortgage. When a tax is not paid, the IRS can levy your assets and take them. It’s the least of two evils to withdraw money from retirement to settle a tax lien or levy.
- To keep from going bankrupt. To avoid filing for bankruptcy, a 401(k) loan may be a viable option. You may keep your house and other valuables even after filing for bankruptcy, but your credit will take a serious hit. Your prospects of landing a job, a professional license, or a government security clearance may all take a hit even after the bankruptcy has been removed from your credit report.
- House Hunting (Maybe). Some 401(k) plans allow you to borrow against your retirement savings for a house down payment and extend the repayment period. That lessens the hit on your salary, but doesn’t get rid of the other hazards involved with payday loans.
Borrowing as little as possible from your 401(k) and agreeing to the shortest payback period can help you reduce the potential negative effects of taking out a loan. That way, you won’t have to forego as much of your retirement savings and the likelihood of your job-hopping helping you pay off the loan faster.
The greatest strategy to avoid tapping into your 401(k) for emergency funds is to plan ahead. Make sure that your regular spending doesn’t spiral out of control by drawing up a budget and sticking to it. If you don’t want once-in-a-while costs, like house and automobile maintenance, to throw off your financial plan, be sure to include funds for them.
There will always be expenses, no matter how good the budget. You can save up for a brake repair that you know is inevitable, but you can’t plan ahead for a big medical emergency or a natural disaster. However, you may prepare for these costs by having adequate insurance coverage and an emergency fund that can get you through a tough situation.