Borrowing From Your 401(k): What Could Possibly Go Wrong?
Here are a couple of key statistics from the National Bureau of Economic Research (NBER):
In any given month, about 20% of workplace retirement account participants will have a loan outstanding against their retirement account.
Over the 5-year period studied, 40% of retirement account participants had, at some point, taken a retirement account loan.
Wow. Did you realize how common it is? And yet, almost every personal finance guru will caution you against doing so. In short, taking out a loan from your 401(k) is pretty much like eating bacon: You know that you shouldn’t, but there is a good chance that you are going to do it anyway.
Is taking a loan from your 401(k) the end of your retirement dreams?
The answer is a bit nuanced.
Let’s start with the math. As you probably know, when you take a loan from your 401(k), or other similar workplace retirement plan, you pay back the loan in monthly installments, usually over five years. There is interest charged on the loan, but it is typically a low rate. And of course, these interest payments go back into your retirement account.
The economic loss by taking a loan comes from the fact that the money taken out as a loan is not earning an investment return until it is put back in. The magnitude of this loss is mostly a function of how much you borrowed, and the investment return it would have earned had it stayed in the account. It may not be terribly serious. For example:
You have an account balance of $100,000 and borrow $10,000 (which is about typical) over five years. During that time, you expect your retirement investment return to be 7%, and the interest rate on the loan is 4.50%. (For reference, this is the loan rate today for TSP — the federal government defined contribution retirement plan.)
Let us also assume that during these five years, you will not make any new contributions to your retirement account. (This is a HUGE point that I will return to later.)
In this scenario, at the end of five years, your account balance will be $139,503. But if you had never taken the loan and, as before, did not make any new contributions during this period, your balance would be very much the same: $140,255.
Here’s my point: It is not the loan per se that can cause havoc with your retirement savings. It’s what else you do while the loan is outstanding!
The problem with 401(k) loans is usually not the loan itself; it’s the fact that many people do not continue to make contributions to their account while the loan is outstanding. In some cases, their employer does not permit them to. But more likely it is the case that many find it difficult to manage the monthly loan repayment while simultaneously contributing new money to their retirement account.
If we return to the scenario above, what happens if you were contributing $300/month to your retirement account, but then stopped for five years as you repaid the loan?
Your $100,000 starting balance would be $139,503 after five years with no new contributions, as we saw before.
If you continued to make contributions while paying off the loan, your balance would be about $160,000 after five years. Big difference, yes?
At the end of the day, a 401(k) loan is like any debt…every dollar that is going to debt service is a dollar that is not working for the future.
So, should you or should you not take a 401(k) loan? Clearly, if you are facing an emergency situation, this may be your best, or even only, option. It’s pretty academic to discuss the downside of not contributing to your retirement in this situation; it’s an emergency!
But what about the decision to use a 401(k) loan for a non-emergency situation, when the alternative is saving up “the old-fashioned way” and delaying the purchase? Consider this first:
Can you continue to save for retirement even as you pay back the loan? Even if your employer does not allow you to make contributions when the loan is outstanding, that does not mean that you cannot save for retirement elsewhere, in either an IRA or a taxable brokerage account.
If you cannot continue to save for retirement while the loan is outstanding, what effect will this have on your retirement security? If you have a very healthy 401(k) balance it may be the case that a (hopefully brief) timeout will not substantively imperil your retirement plans. But if your savings are already low, taking out a loan will only set you further back. Is your future financial security worth the risk?
If you do not make contributions while the loan is outstanding, will you miss out on your employer match? Do not leave free money on the table, people! Even if you cannot make the same contribution that you were making before the loan, at least keep up the minimum amount to maximize your employer match.
Is this your first 401(k) loan or your tenth? If you are dipping into your 401(k) account repeatedly, this is a big red flag that there is a need to re-think your broader financial plan.
Will you be able to pay the loan back before you leave this employer? Overall, almost all 401(k) loans are repaid as agreed. But among those who leave their employer with a loan outstanding? Almost all (86%) default!
When you leave employment with a loan outstanding, a few different things can happen. Your employer may allow you to continue paying back over the original period, but very often you must repay the loan in full fairly immediately. If you do not, the loan is considered “defaulted.” And what that means is that the entire amount borrowed is considered to be a distribution from your retirement account. Not yet old enough for penalty-free retirement plan distributions? Now you have a 10% penalty to pay when you file your taxes the following April, as well as income taxes on the amount withdrawn! It’s not a pretty scenario.
To end where we started, the decision to take a loan from your 401(k) does not fall neatly into good and evil, black and white categories. For some, it can be a perfectly valid choice. My fear, frankly, is that a 401(k) loan is often a symptom of a larger financial planning shortcoming. The question is not so much “Should you take a 401(k) loan?” but rather, “Why do you want to?”
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