The good news is that the 401(k) has become one of the primary sources of retirement savings for most Americans, with 74 percent of workers actively participating in these plans, according to the Employee Benefits Research Institute (EBRI). The bad news is that some workers view these savings as a piggy bank they can tap into to pay for life’s incidents, including a new car, a vacation or any of a number of surprise expenses for which they did not previously plan. As tempting as it may seem to borrow money from your own savings, you may want to stop and think about all rules for taking a loan from your 401(k) plan and the potential problems that doing so may cause.
The Rules for Borrowing from a 401(k)
Borrowing money from your 401(k) is fairly simple. For one, you do not need to provide a reason for taking out a loan, which can be as high as $50,000 or half of vested balance. In most cases, you will be allowed five years to repay the loan at interest rates that are significantly lower than those offered by a bank. Moreover, your repayment of loan principle is typically conducted through an automatic payroll deduction, for which your interest payments will go directly to you rather than a bank of other third-party lender.
As attractive as this sounds, however, taking a loan from your 401(k) plan can yield some significant challenges.
Pitfalls to Borrowing from a 401(k)
Some workers rely on their 401(k) savings as an interest-friendly revolving line of credit to pay for everyday expenses rather than a vehicle for helping them reach their retirement goals. The common justification of “it’s my money, I saved it, I can borrow from myself” can put a significant dent in your retirement strategy. When you take this money out of the market, you could be missing out on potential opportunities for appreciating investment returns. Additionally, you may find yourself strapped for cash during the repayment period, as the loan principle and interest will be automatically deducted from your paycheck. Not only could this limit your ability to keep pace with your retirement strategy and catch up on 401(k) contributions and a potential employer match, but it may also leave you without access to money to pay for a real hardship should a catastrophic, life altering event occur.
One of the most significant risks to individuals who borrow against their 401(k) plans is the very real possibility that they may lose their jobs – either voluntarily or due to a layoff – before repaying the outstanding loan balance. Under these circumstances, the borrower will need to either pay the unpaid balance in one lump sum or treat it as a 401(k) distribution that is subject to income tax as well as a 10 percent penalty when the borrower is younger than 59 ½.
Finding Alternative Options
Workers should give careful consideration to whether or not an intended 401(k) plan loan is truly needed, or if it is simply a short-term desire for access to cash. While the Department of Labor and the IRS do allow workers to take hardship withdrawals due to “immediate and heavy” financial burdens, these loans come with the costs of ordinary income taxes and early withdrawal penalties. Even under the most desperate financial circumstances, borrowing from a retirement plan should be last-resort option. Instead, individuals should meet with experienced financial advisors to understand all the alternative options and resources available to help them meet their immediate needs.
About the Author: Olga Ismail is a retirement plan consultant with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors and Accountants, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
Provenance Wealth Advisors (PWA), 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Olga Ismail is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants.
Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/deal and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of PWA and not necessarily those of Raymond James. You should discuss any tax or legal matters with the appropriate professional. The information contained in this report has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete.
401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Investments mentioned may not be suitable for all investors. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.