Is Borrowing From Your 401(k) a Good Idea?
In many cases, yes — but make sure you know these 5 crucial rules before taking out a loan
Richard Eisenberg is the senior Web editor of the Money & Security and Work & Purpose channels of Next Avenue and Assistant Managing Editor for the site. Follow him on Twitter @richeis315.
In his "Making Sen$e" column, Solman focused on whether it's advisable to “pull money” from a retirement fund, like a 401(k), rather than going into credit-card debt.
What Paul Solman Thinks
Solman's wisdom: Taking out a 401(k) loan to avoid deep credit-card debt absolutely makes sense, generally speaking.
(MORE: Are Americans Really Able to Manage Their 401(k) Plans?)
His rationale, assuming your plan allows loans: When you borrow from your 401(k) — by law you can withdraw up to $50,000 or half the account's value, whichever is lower — you’re paying the interest to yourself as you repay the loan. So, Solman says, the net cost is zero. (I have some views on this, below.)
I agree that taking out a 401(k) loan instead of running up a high-interest credit card can be a smart financial move. There’s very little paperwork and you won’t go through a credit check.
Indeed, 21 percent of all Americans with 401(k) plans (22 percent in their 50s) have taken out a loan, according to the Employee Benefit Research Institute. Minorities are nearly twice as likely to dip into their retirement accounts: The Ariel/Aon Hewitt study, "401(k) Plans in Living Color," found that 49 percent of African-Americans and 40 percent of Hispanics of all ages took 401(k) loans in 2010, compared with 26 percent of whites.
(MORE: Big Changes Coming to 401(k)s in 2012)
5 Things You Should Know
Before you jump in to borrow from your 401(k), however, keep in mind these five crucial facts:
1. You will owe interest. Employers set their own rates, but typically charge between the prime rate (now 3.25 percent) and the prime rate plus two percentage points (5.25 percent, currently). That's much lower than the double-digit interest rates charged by many credit cards, though.
2. The loan must be repaid within five years, in most cases. If you’re borrowing to buy a home, you’ll have more time — perhaps up to 15 years. The exact term depends on the employer. If you don't pay it off in the prescribed time, the IRS will consider this an early withdrawal and you'll owe taxes plus a penalty if you're younger than 59 1/2.
3. If you lose or quit your job, you must repay the loan within 60 days. Otherwise, the IRS will consider it a taxable distribution. That means, you’ll pay income taxes on the amount owed plus a 10 percent tax penalty if you’re under 59½.
Many borrowers get tripped up by this rule. In fact, nearly 80 percent of workers who left their jobs with 401(k) loans defaulted on them, according to the Financial Literacy Center, a project of the RAND Corporation, Dartmouth College and the University of Pennsylvania Wharton School.
So think long and hard before taking out a 401(k) loan if you believe you might leave your job within five years.
4. The money you borrow won’t earn the tax-deferred income it would otherwise generate in a 401(k). That may sound obvious, but it’s worth a reminder. Bankrate.com has a useful Should I Borrow From My 401(k)? calculator that can help you run the numbers.
5. You may be barred from contributing to your 401(k) plan while you have the loan. Some employers don't permit contributions and loans simultaneously; some don't match contributions while a loan is outstanding. You'll want to check with your employer about its rules. If you're allowed to invest in your plan while you have a loan and can afford to do so, you should.
Time to Change the Law
Personally, I think it’s time to amend the law regarding the amount of time you have to repay a 401(k) loan if you lose your job or quit.
The current 60-day repayment requirement is terribly strict. I endorse proposals by the Ariel Education Initiative and AON Hewitt to extend the deadline to 12 months and to allow a grace period to individuals collecting unemployment benefits.
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