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.
Is It a Good Idea to Take Out a 401(k) Loan?
In short: not really. While there are some situations in which a 401(k) loan isn't the worst course of action, it generally shouldn't be your first option. "In a perfect world, you wouldn't want to borrow from your retirement account," says Blaylock. "As a society, we’re undersaving for retirement already."
Taking out money—even if it's just a loan, not a withdrawal—goes against the most deeply ingrained tenets of saving for retirement (namely, "Hands off!"), and apparently, it can be habit-forming: A Fidelity survey found that once you borrow from your 401(k), you're more likely to go back for another loan.
Before considering borrowing from your savings, you should ask yourself the following questions.
1. Do I Need This Money for a Short-Term or Long-Term Fix?
One of the biggest problems with 401(k) loans, says Blaylock, is that they don't actually solve anything. "I don't recommend them, because to me, they don't make any sense," he says. "If you can't afford it without a 401(k) loan, you probably shouldn't be doing it."
He explains that 401(k) loans are most problematic when they let you ignore larger issues at play. "Are you borrowing for a short-term need or a long-term need?" he asks. "If this is a long-term issue with cash flow, the 401(k) loan will probably just band-aid that problem, not fix it. If it’s short term, like needing to buy a house today and intending to pay it back next month with your bonus, I can get behind it. But, in my opinion, loans should only be used for short-term fixes."
One example of this situation is credit card debt: While it might be tempting to take out a 401(k) loan to pay off your credit card debt at a lower interest rate, "I see many people do this and charge the card right back up," cautions Blaylock. "They need to address why they had credit card debt in the first place, or the 401(k) loan may enable them to dig an even deeper hole." He doesn't recommend using a 401(k) loan to pay down credit card debt unless it's an extremely high interest rate that will take over five years to pay off at your current payment amount. Even so, you should look at the underlying habits and figure out how you racked up the debt in the first place, or history may repeat itself.
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2. Have I Researched All of My Options?
Granted, 401(k) loans are usually convenient—but as Blaylock says, "It shouldn't be a convenience issue. For most people, if we’re really resourceful, there are other places to borrow money. You should look at all your options before tapping your retirement assets."
If you've been diligent with your savings, you may already have two of these options in your own financial portfolio: First, your emergency fund, which we recommend should hold at least six months of net income to use in case of an emergency. As a reminder, these are things like medical expenses or bereavement costs—not house purchases. For items that may be less urgent, you may want to consider turning to your second option: your personal escrow, the savings account that holds money for non-monthly payments or unforeseen expenses separate from the rest of your savings. If you can divert funds from either or both of these accounts, you may be able to avoid taking a loan altogether—and if you don't have either of these funds, now is a great time to consider getting them started.
If you need to go the loan route, Blaylock suggests looking into home equity loans (if you own your home, the interest from these loans is often tax-deductible, as mentioned above) or consumer lending sources such as peer-to-peer lending or lending clubs. "Yes, there are some excusable reasons to take out a 401(k) loan," says Blaylock, "but overall, it should be a last resort."
LearnVest Planning Services is a registered investment adviser and subsidiary of LearnVest, Inc. that provides financial plans for its clients. Information shown is for illustrative purposes only and is not intended as investment, legal or tax planning advice. Please consult a financial adviser, attorney or tax specialist for advice specific to your financial situation. Unless specifically identified as such, the people interviewed in this piece are neither clients, employees nor affiliates of LearnVest Planning Services, and the views expressed are their own. LearnVest Planning Services and any third parties listed in this message are separate and unaffiliated and are not responsible for each other’s products, services or policies.