Though surveys show the average investor is not saving enough for retirement, some have done pretty well, using large contributions and handsome stock returns to build substantial holdings. But for many, a 401(k) is the most substantial account, perhaps the only account, and in an emergency the investor is likely to face a hefty tax bill and penalty for taking money out.
That’s where a 401(k) loan comes in. Used right, a loan can be an inexpensive way to get money out of the 401(k) before qualified withdrawals are permitted after age 59.5. With accounts flush from stock market gains of recent years, it may look like a good time to borrow, especially if you think you’ll have a chance to repay after a market dip.
But experts say a loan is not to be taken lightly, as it can severely undermine investment performance afterward.
“We recommend avoiding 401(k) loans as much as you possibly can and only using them as a last resort,” says Andrew Thomas, investment advisor at Blooom, an online 401(k) management service. “There are far better options to pay down debt or for the unexpected expense.”
[See: 7 Things That Can Derail Your Retirement Investing.]
As most 401(k) investors know, these workplace accounts allow the participant to set aside up to $18,000 a year, or $24,000 if 50 or older. Many employers match the employee’s contributions to some extent. Neither contribution is included in the employee’s annual income, producing a substantial upfront tax savings. Annual income or gains from shifting money among holdings are not taxed on an annual basis; all taxes are deferred until money is withdrawn after the investor turns 59.5 and money taken out after that is taxed as income.
Except in certain cases, withdrawals before the investor turns 59.5 are taxed and subject to a penalty of 10 percent. That means money is tied up and not available for ordinary expenses, emergencies, a home down payment or other needs. That can be a serious problem if the 401(k) is the participant’s main investment.
A 401(k) loan is an option, if the employer allows. Federal law allows a loan of up to half the account value, or $50,000, whichever is smaller. Defaulting makes the outstanding loan balance into a withdrawal subject to income tax and, if the borrower is not 59.5, the 10 percent penalty.
While there is no federal restriction on how loan proceeds can be used, David Gratke, CEO of Gratke Wealth of Portland, Oregon, says funding emergencies is most common.
“We just had a client tap a 401(k) loan due to a high, unexpected tax bill,” he said. “Unforeseen emergencies are usually justified. A 55-inch curved $4,000 LCD TV at Costco, not so much. That’s the foolish side.”
Most employers have restrictions of their own, like requiring evidence of a hardship, he says.
As with most loans, there is an interest charge. But instead of paying a bank or other institution, the borrower pays interest back into the 401(k) account, so the interest payment adds to the account value rather than subtracting. Interest rates are set by the employer but are often 1 or 2 percentage points above the prime rate, currently 4.25 percent.
The debt typically has to be repaid within five years, or tax and penalty apply to the balance.
So what’s not to like? It sounds like a win-win, a great way to finance a new car, pay a semester’s tuition, redo the kitchen or pay down some high-interest credit card debt. With a 401(k) loan it seems like you earn interest instead of paying it.
Experts warn, however, that it’s not quite that simple.
The biggest negative is how the cash is raised. Unlike a margin account, which is a loan using securities as collateral, a 401(k) loan involves selling assets in the account. That will reduce your investment gains.
[See: 12 Steps to a Stronger 401(k).]
“The biggest drawback to these loans is opportunity cost that comes with the missed potential growth of your investments,” Thomas says.
“People typically stop contributing to their 401(k) while repaying a loan, which means they are also missing out on their employer match,” he says. “These are huge setbacks to the average American, and there are usually many other options to consider before dipping into your nest egg early.”
Another concern: Though it’s nice that the interest is paid into your own account, that’s still money you have to come up with out of ordinary income or by tapping other investments.
A 6 percent loan of $50,000 would cost $3,000 a year in interest, $15,000 over five years. If you took out the loan because you were in a pinch, interest charges could be a burden even if the rate looked low compared to credit card rates. Money used to repay is typically after-tax money — it’s not tax deductible like the original contribution.
In effect, the loan offsets one of the chief benefits of a 401(k), the upfront tax deduction.
But what if you’re not in a pinch? Would it make sense to use a 401(k) loan as a convenient alternative to a loan with a higher rate?
It might seem that way if interest rates were the only consideration, but those lost investment gains should be counted too. With big U.S. stocks in the Standard & Poor’s 500 index up more than 15 percent this year, someone who borrowed $50,000 Jan. 1 would have missed out on about $7,500 in gains. And paid interest on top of that.
“It’s important that we focus on the fact that we’re talking about a retirement account that likely has decades until it will be used for retirement income,” Thomas says. “That time is extremely important for growth. There will be many market peaks and troughs between now and then, and trying to predict the perfect moments to get in and out of the market is a recipe for disaster for a nest egg. We focus on time in the market rather than timing the market.”
Although 401(k) loan rates seem cheap, there may be better alternatives, says Dwain Phelps, owner of Phelps Financial Group in Kennesaw, Georgia.
“If your credit is good (670 or above), then you may want to explore other options that would give you favorable rates,” Phelps says. “There are personal loans that can be taken from credit unions, banks and equity lines of credit wherein interest is probably deductible. This may be an option to consider since 401(k) interest is not deductible. On the other hand, if your credit is poor (below 600), then taking a loan from your 401(k) plan may be a great alternative to address a short-term financial need.”
Another worry is what happens if your work life sours, Thomas says.
[See: 10 Ways to Avoid the IRA Early Withdrawal Penalty.]
“If you leave your job, you will likely be required to pay back all of your remaining loan balance in a single balloon payment or over a very short period of time,” he says.
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Why You Should Avoid 401k Loans originally appeared on usnews.com
