When you’re desperate for a loan, borrowing money from your 401(k) can be very tempting. After all, it’s your money, there’s no credit check and you pay yourself interest. But experts warn that pre-maturely dipping into your 401(k) should be your last resort after exhausting all other options.
“It’s not so much the 401(k) loan but the loan itself,” says Joseph Montanaro, certified financial planner at USAA. “If you can make it through the filter that you need the loan, at that point it becomes a question of the best way to get a loan from a financial perspective.”
With credit markets still thawing from the 2008 freeze, money from a retirement plan could be a good option for cash-strapped consumers, but chartered financial analyst Robert Stammers, director of Investor Education for the CFA Institute, says borrowing from your 401(k) should only be an option if you’re unable to get a loan elsewhere and can pay the loan back within a reasonable amount of time.
Experts recommend asking yourself a few questions before you borrow from your 401(k) to make sure you don’t create a financial disaster down the road.
What are the loan terms? 401(k) loans have a fixed interest rate that’s set at 1% to 2% over the prime rate, which is currently 3.25%. How long you have to repay the loan depends on why you’re borrowing money—with terms for general purpose loans at five years and up to 15 years given to repay money used for a primary home purchase, according to says Catherine Golladay, vice president of Participant Services at Charles Schwab.
What if you don’t pay it back? These loans provide cheap money only if you’re able to repay it. When you don’t repay the loan, it becomes ordinary income and is taxed at your bracket, according to regulations from the IRS.
Depending on your income, a loan that becomes ordinary income could bump you up to a higher bracket, warns certified public accountant David Bendix. If you’re married filing jointly and your income crosses above $69,000, or $34,500 for filing single, for example, the additional income can increase your marginal tax rate from 15% to 25%, according to the IRS 2011 tax rates.
If you’re under the age of 59.5, you’ll also pay a 10% penalty. “If your income is low, you may not have a big tax impact but you’ll still have that penalty,” says Bendix.
Is your job secure or do you change jobs often? “Assuming you don’t repay your loan, or get terminated or leave your job, then [the loan] is a taxable event,” says Bendix. Consider your job situation and whether you have job security; if you leave your job for any reason, the full amount of the loan becomes due in a lump sum within 30 to 60 days depending on the rules of the 401(k).
Where will your money earn more? Experts suggest considering whether you’ll earn more with your money invested or by paying yourself interest. “You could potentially give up the opportunity cost of money not invested in the portfolio,” says Montanaro.
Before you borrow, “do an apples-to-apples comparison on whether the rate you pay yourself back is better than what you’d earn in one of your plan’s options,” advises Golladay. “You’re definitely giving up any upside in market appreciation.”
Pulling money out of a 401(k) in a down market isn’t that detrimental since you pay yourself interest, says Bendix.
Why are you borrowing the money? “Assessing whether or not you need the loan is a big deal,” says Montanaro. “If you’re short money, from a cash flow perspective, taking a loan is a band aid and not a fix.” In this instance, he advises addressing the core problem by increasing your income or decreasing your expenses.
Bendix advises borrowing from your 401(k) only for financial emergencies or a stopgap—like when a family needs an extra $10,000 to buy a new home, and know they will be able to pay back the money quickly.
Experts suggest considering why you need the money before dipping into a retirement account. “It doesn’t make sense to borrow for something frivolous like a car or vacation,” says Stammers. “You’re using long-term savings for short-term goals.”
Even though you may tap into your retirement account like it’s revolving credit, this is your future and your retirement nest egg, says Golladay. “Oftentimes, people fall into bad habits. A lot of individuals look at their 401(k) as a savings account.”
If you’re looking to borrow to pay off other debt, experts suggest reviewing your budget to cut expenses instead. “The potential is there with the 401(k) loan to have the same set of problems—ending up with a whole bunch of new debt along with the 401(k) loan,” says Montanaro.
When you should consider tapping into your 401(k):
To buy a house. If the additional funds help you get better rate by putting more money down, it could make financial sense to borrow, says Stammers. Generally, these borrowers try to repay the loan within six to nine months even though the loan can be repaid in up to 15 years.
If you can repay the loan and still contribute. Oftentimes, when people borrow from their 401(k), they stop or reduce their contributions, says Golladay. Sometimes they can’t afford to contribute and pay back the loan at the same time.
Instead of borrowing money, experts suggest reviewing your contribution amount and balancing your budget. Using a 401(k) loan to pay down high interest rate debt may make sense. If you do this and are forced to stop future contributions, you’ll lose the company match—this is free money and part of your compensation, says Bendix. Lowering your contribution amount may be a better option.
Saving for retirement is important—you can borrow for tuition or to buy a house but you can’t take a loan for retirement, says Golladay. “Pay yourself first and forget about the money. Let it grow for you, and don’t rob your future.”