401(k) Loans: What You Should Know
When Ivy Simon, a 39-year-old from Chapel Hill, N.C., wanted to buy her first house in 2006, she borrowed $50,000 from her 401(k) for a down payment.
She paid back her loan easily, within two years. “I’m glad I did it, and I would do it again,” says Simon, who is now the owner of Palette and Parlor, a home design and decor business in Chapel Hill, NC. “I’d rather owe myself the money than a bank or someone else.”
Simon isn’t the only one who feels that way.
According to a study by Ameriprise Financial, 17% of Millennials have taken a loan from their employer-sponsored retirement plan—although the younger generation, farther away from retirement, tends to be more loan-happy than their older counterparts Gen X (13%) and Boomers (10%).
But keeping in mind that most workers have frighteningly little saved for the 30-plus years after work, shouldn’t retirement funds be used for … retirement? David Blaylock, CFP® with LearnVest Planning Services, explains why savers might turn to their 401(k) for funds—and whether it’s an option you should consider.
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What Is a 401(k) Loan?
According to a study by the Employee Benefit Research Institute, 87% of 401(k) plans offer loan options, which sets these workplace retirement accounts apart from traditional IRAs, which don’t offer loans under IRS regulations—only early withdrawals made before age 59 ½, which mean you may incur a 10% penalty tax.
There are a few exceptions to the penalty tax for withdrawals from traditional IRAs, however: If you’re using that money to pay for college for yourself, your spouse or your child; if you’re covering medical expenses that exceed 10% of your adjusted gross income or you’ve been unemployed and without heath insurance for at least three months; if you’ve been severely disabled; or if you’re withdrawing up to $10,000 to buy a first-time, primary home.
The same rules apply for withdrawals from Roth IRAs, as long as you’ve had the account for at least five years, with the added caveat that you can withdraw your contributions any time, since you’ve already paid taxes on them. MarketWatch and H&R Block offer additional information about situations in which you may be able to make a penalty-free withdrawal from either account, or you can learn more on the IRS website.
The 401(k) loan, however, typically allows a person to borrow up to 50% of his or her account balance up to a maximum of $50,000 but requires it be repaid within five years—though the repayment schedule may be extended if you’re using the money for a down payment on a home. The loan doesn’t have to be approved by a bank, which means you can usually get your hands on the money quickly and without a credit check. Plus, interest rates may be lower than on standard bank loans.
How Can You Pay It Back?
You’ll typically repay the loan through automatic deductions from your paycheck, which may sound easy, but keep in mind that while it may seem “safe” to owe yourself money, it isn’t without consequence. If you don’t make a payment for 90 days, that money is considered a distribution and taxed as income, plus a 10% penalty if you’re under 59 ½. And, if you leave or are let go from your job, you must repay the entire loan within 60 days or incur those same financial penalties.
Plus, the lack of a substantial upfront cost to the loan may not be as good as it sounds. “While your 401(k) provider might tell you that you can borrow the money for free,” explains Blaylock, “it isn’t free. That money isn’t earning anything until it’s back in your account, plus, the interest payments aren’t tax-deductible as they would be with something like a home equity loan. That’s your borrowing cost.” Not to mention that you’re undoing all the hard work it took to get that money into your retirement savings in the first place.