A co-worker tells you how quick and easy it is to get a loan from your 401(k) account. He sells you on the low interest rates and “no credit check.”
So, should you throw caution to the wind, snag the loan, and start brushing up on your Dutch?
Probably not, and there are some very good reasons why.
401(k) Loans: Interest Rates, Taxes and Fees
Interest rates, taxes and fees are terms that keep us up at night wondering if a loan was really worth it. You should understand how they work before taking out any loan, even one from yourself, like a 401(k) loan.
Like most loans (except maybe those from Mom and Dad), a 401(k) loan comes with interest. The rate is usually a point or two above the prime rate. Right now, the prime rate sits at 5.5%, so your 401(k) loan rate will come out between 6.5% and 7.5%.
The interest rate is the same regardless of your credit score, which is one reason why so many people find 401(k) loans tempting. According to the Investment Company Institute (ICI), 19% of people eligible for 401(k) loans have loans outstanding.
In this case, you’re paying interest to yourself, not to a bank or your employer. People like to call this transferring money from one pocket to another, but it’s not that simple.
Know that while your money sits safely in your 401(k) account it’s accruing compound interest, which has been described as the “eighth wonder of the world.” That’s because compound interest means earning interest on the interest you earned, which means your money compounds at an ever-accelerating rate, which is a very, very good thing.
However, the more money you take out for a loan, the less your account will appreciate.
Paying yourself interest allows your retirement account to stay on track. If you keep up with your payments, you’ll still have a balance around what you would have had, if you had kept your hands off the nest egg.
The difference is you had to pay extra out of pocket to build that balance, instead of sitting back and reaping profits from the market.
What’s the beauty of a typical 401(k)? The money you put away is untaxed, at least for a while. You won’t be taxed until you start withdrawing in retirement. Most of us will have lower incomes by then, thus putting us into lower tax brackets.
Now if you go ahead and take that loan, there will be major tax implications. You’ll get smacked with a tax on the interest you pay back to yourself, and you’ll get taxed again when you withdraw during retirement. That’s called double taxation and yes, it’s legal.
Another thing to keep in mind: if you lose or leave your job before repaying your 401(k) loan, the IRS will expect you to repay the loan in full by the next tax year. So, if you leave your job in the spring of 2019, you’ll owe the entirety of the loan by April 15, 2020.
The IRS can be staved off for a while If you find a job with another 401(k) account to transfer your loan to, but don’t bank on it. About 86% of workers who leave their job with an outstanding 401(k) loan, go on to default.
Fees seem to sneak their way into every financial transaction we make and 401(k) loans are no exceptions. Origination fees range from $50-$100. Some come with a maintenance fee that can cost you $25-$50. If the loan is large enough, you might shrug off a fee of $75 or $150. But if you’re only borrowing $1,000, you’re losing up to 15% from the start.
You’ve got five years to pay the loan back. If you fail to do so, the IRS will consider it a distribution and slap you with an income tax, plus a 10% early withdrawal fee. This is hard to swallow no matter how large or small the loan is. If you borrowed the max amount of $50,000, you’d owe the IRS $5,000 in early withdrawal fees alone!
How Much Can Be Borrowed from a 401(k) Loan?
It depends on how much you have in your account. You can borrow up to 50% of your vested account balance, but you can’t borrow more than $50,000. Even if you have a balance of $200,000, the IRS won’t let you touch more than $50,000 of it.
The only time you can borrow more than 50% is when you have a balance of less than $20,000. In that case, you can borrow up to $10,000, even if you only have $10,000 stashed away.
When to Borrow from your 401(k)
Only borrow from your 401(k) when no other reasonable loan rates are available and only if the situation is dire.
Vacations are ruled out. So are 50-inch 4K TVs, shopping sprees and any form of consumerism that might be considered excessive. There are, however, emergencies or dead-end scenarios when a 401(k) loan may be your best or only option.
If you’re suffering a medical setback and need cash fast, your 401(k) may be a good place to look. You may even qualify for a hardship withdrawal. In this case you won’t have to pay the loan back, but you’ll still have to pay income taxes, plus the 10% early withdrawal fee.
The qualifications for hardship withdrawal differ from plan to plan. Check with your employer to see what yours may cover.
If you’re looking at your 401(k) as a way out of debt, you’re looking in the wrong direction. Debt (especially credit card debt) is often the result of undisciplined spending or an unforeseen emergency like job loss or medical setback. It’s rarely a one-time purchase that sends the consumer into financial despair.
Alternatives to Borrowing from Retirement
Dipping into your 401(k) likely will lead to more troubles than it’s worth. There are other ways to get by while keeping your retirement funds intact. Learn more about prioritizing retirement vs paying off debt.
Here are some methods of dealing with a financial emergency:
- Home equity loan – This is a good option for homeowners. It comes with a fixed interest rate that never changes. Right now, the average home equity loan rate is 7.74%.
- A personal loan – Even if the interest is higher than you’d like, it’s often better than interfering with the appreciation of your 401(k). If you have a credit score above 720, you may be able to find interest rates around 10%.
- Nonprofit credit counseling – Maybe you don’t feel comfortable putting your home up for collateral,or your credit is too low for a decent interest rate on a loan. Consider working with a nonprofit credit counseling agency. A credit counselor will take a look at your budget, walk you through your spending habits and help you establish a more manageable financial lifestyle.
A 401(k) is first and foremost a retirement account, not just a second savings or vacation fund. The tulips have been blooming in Holland for 400 years. They’ll be around down the line when you’re financially ready and able.
In the meantime, keep making contributions to your 401(k). Let it sit. Watch it grow. You’ll thank yourself later.