So many people seem to be borrowing from their 401(k) plan accounts these days, but is it really a good idea? Proponents often point to the following:
- If your plan offers loans, it’s easy to get one. Your credit score has no effect on your qualification, and the loan and its repayment won’t affect your credit score.
- Plan loans are normally at very reasonable interest rates – less than you may think.
- Your plan loan repayments are applied to your plan account exclusively, so you are actually paying yourself back with interest.
- If your other plan investments are continually underperforming or are subject to high fees, such as may be the case for plans that participate in revenue sharing agreements with mutual fund companies, or if you are paying extra to have your investments managed, the rate of return you pay yourself on the plan loan could appear to be a better investment for you.
Sounds pretty tempting, doesn’t it? Let’s dig a little deeper, though. Here are some things you may not have realized:
- The rate of return you pay yourself on a plan loan is likely a worse investment for you (a loss of earnings). Investing in low-risk options, including plan loans, provides almost no potential growth for your money. Investing in the stock and bond markets over the long-term is your only chance to produce the level of wealth needed for retirement.
- Most plans charge a loan origination fee and an annual loan maintenance fee, each of which could easily be $75, $100, or more. These fees are paid directly from your plan account.
- Unless you borrow from Roth elective deferrals you have made, plan loan proceeds consist of previously untaxed money. Although you fundamentally repay your loan principal with these proceeds, you will be paying the interest with new take-home pay, which is net of tax. Therefore, you will be paying double tax on the interest paid on your plan loan:
- once as it is being paid each pay date, and
- again when you withdraw money from your plan account for use in retirement.
- You may find yourself decreasing your contributions to your plan in order to afford the plan loan repayments. Some plans even prohibit making elective deferral contributions while you have an outstanding plan loan. A plan loan can derail your retirement savings goals in a major way.
- If you leave your job before the loan is paid off, you must either pay off your loan balance in full, or you must report the outstanding balance as taxable income on your federal tax return. If you are under age 59 1/2, you will also incur a 10% excise tax penalty. Talk about unexpected expenses!
OK, so this is a lot of information. Suffice it to say that 401(k) plan loans generally should be avoided if at all possible.
Well, the thing is, you really need the money – that’s why you’re considering a plan loan in the first place, right? If you’re really and truly in a bind, by all means, go there. However, think about the following alternatives:
- If you own your home, you may be able to refinance your mortgage and utilize a cash-out option, or you could take out a home-equity loan.
- If you need money for education costs, look into a federal student loan instead.
- Are there some expenses you could cut back on or renegotiate to free up some money? There is an unbelievable amount of free advice about this on the internet.
- Have you thought about getting a second, part-time job? This could even be as simple as the following:
- Do occasional odd jobs for neighbors or seniors (think snow shoveling, lawn care, dog walking, taking care of plants and pets while they’re on vacation, etc.).
- Make and sell crafts. You’d be surprised how many events provide selling opportunities and, again, free advice on the internet.
- Sell surplus garden produce at your local farmers’ market.
- Have garage or yard sales or sell items at flea markets, antique stores, or online.
- Have you considered crowdfunding? There are a good number of websites for this now.
- If you smoke cigarettes, stop. This is an expensive habit.
- As a last resort, can you borrow from a relative?
There are other options out there too – just take some time to do a little research. Believe me, if you can avoid taking a 401(k) plan loan, your future self will thank you. We are all living longer than ever, and by all accounts, we are all saving too little for our retirement. It’s time to let the Information Age work to your advantage, so get creative and be resourceful!
Written by: Debi Ondrik, CPA