Our 401 (k) allows you to borrow from the plan and pay back with 7% interest.
With today’s sometimes dismal returns, it seems like a great way to pay off debts or make a down payment. I know you’re missing out on the winnings, but in some situations, wouldn’t you rather pay that 7% yourself?
Mathematically, I can’t tell you if you’ve got a 401 (k) loan if you’re ahead of the curve. It depends on so many factors such as the interest rate you are currently paying on the debt that you are using the loan on and market trends.
In general, however, borrowing from your future is bad business – even if you are paying yourself interest.
First, a quick 411 to 401 (k) loan: Not all employers will let you borrow your 401 (k) loan. However, if your plan allows for loans, the IRS says you can borrow up to 50% of your vested balance or $ 50,000 – whichever is less.
The loans are tax-free and are usually repaid through automatic wage deductions. The interest you pay goes back into your retirement fund so the appeal is obvious. Of course, you’d rather pay interest to yourself than to a bank.
However, as you acknowledge, you are missing out on potential gains that could be substantial thanks to compound returns. This effect is even greater if you reduce or cancel your contributions while you are paying back your loan, as many 401 (k) borrowers do, or if your employer does not allow you to contribute while you have an outstanding loan.
The real danger, however, is when things don’t go as planned.
If you leave your job for any reason, you will need to repay the outstanding loan balance in full when you file this year’s tax return. So if you have been made redundant or quit your job at any point in 2019, you will need to repay your 401 (k) loan by April 15, 2020 or October 15, 2020 if you submitted an extension.
But what if you can’t afford to pay it back? Then it will be treated as an early withdrawal by the IRS, which means you will pay income tax plus a 10% fine if you are under 59 1/2 years old. For example, let’s say your outstanding loan balance was $ 10,000 and is taxed at the 22% class. With taxes and the penalty, this $ 10,000 loan would cost $ 13,200.
The risks are real. A 2015 study by the National Bureau of Economic Research found that 86% of 401 (k) borrowers who quit their business have defaulted on their loan. (Precaution: At the time of the investigation, 401 (k) borrowers only had 60 days to repay their loans after leaving their jobs. The Tax Cut and Jobs Act 2017 extended the time frame.)
Also, keep in mind that a 401 (k) is an asset that is protected from creditors. So you should be extra careful when using it to pay off debts or for real estate that could be confiscated during difficult times.
There may be a few circumstances where robbing your 401 (k) is your least bad option – if you have a serious illness or are about to lose your home. If so, I would at least consider a 401 (k) loan.
But that doesn’t sound like that here. If you want to pay off debts and have adequate credit, a debt consolidation loan is a better option. Sure, you will exceed the interest rates on a lender, but it’s a lot less risky than a 401 (k) loan. Or if you want cash on a down payment, finding a down payment support program or good old fashioned savings are better options for the long haul.
It is frustrating to see your retirement assets rise and fall in a volatile market. However, keep in mind that these ebbs and flows are usually relatively small. Saving for retirement is a long-haul game, and short-term swings are by and large not a big deal.
The purpose of your 401 (k) is to help finance your retirement. Until then, the best advice is: Do not. Touch.
Robin Hartill is the Senior Editor at The Penny Hoarder and the voice behind Dear Penny.