As the economy hiccups, more workers are turning to 401(k) loans for emergency cash. According to a recent study by the Transamerica Center for Retirement Studies, 18% of U.S. workers took a 401(k) loan last year. That’s an increase from 11% in 2006. Taking a loan from your 401(k) account is not difficult, but it’s not a good idea.
The temptations to take a 401(k) loan are plenty: to make a down payment on a home, to pay down high interest credit card debt, or as an alternative to traditional loans amidst a tighter lending market.
So, What Is a 401(k) Loan?
A 401(k) loan is a lump-sum disbursement from funds that you have saved in your retirement account. You must repay the loan over a fixed-amount of time – with interest – back into your 401(k) account. You can borrow between sixty and eighty percent of your 401(k) balance, and occasionally up to the full account value. The loan is set-up through your 401(k) plan administrator.
In some ways, a 401(k) loan seems like a good idea. Essentially, you borrow money from yourself, so interest charges go right back into your retirement account instead of to the bank. And, since it’s secured by your own money, there is no credit check to take a loan, and you can’t default and find creditors knocking down your door.
Why 401(k) Loans Are Bad
Despite these apparent benefits, 401(k) loans are a bad idea for two reasons. First, when you borrow money from your 401(k), those funds stop earning compound interest until they are repaid. Even if your 401(k) balance is small, a couple hundred dollars in interest over a few years could turn into many thousands over 30 years.
Even more important, contributions (including loan repayments) to your 401(k) are dependent on you being eligible to receive that benefit from your current employer. If, for any reason, you leave your employer, the entire balance of your 401(k) loan becomes due.
Can’t pay up? The remaining loan balance will be treated as a pre-mature cash withdrawal form your 401(k), subject to at least a 20% federal income tax, state tax, and a 10% early withdrawal penalty. So if you borrowed $10,000, had repaid $2,000, and lose your job – you are freed up from repaying the $8,000 to your retirement account, but you will be hit with a $2,400 federal tax bill.
That’s one expensive loan.
How to Take a 401(k) Loan
If you’re really in a pinch, or absolutely can’t get an alternative loan source, you can take a 401(k) loan by talking to your human resources or benefits manager at work, or by logging into your 401(k) plan’s website. Some plan providers – including John Hancock and Fidelity – allow you to request loans online.
- The 401(k) Plan: An Introduction
- How Much Should Be In Your 401(k) at Thirty?
- 401(k) Vesting and Changing Jobs: Should You Stay or Should You Go?
Have you taken – or considered taking — a 401(k) loan? Why did you do it, and how did it work out?