Whether you're consolidating debt or replacing the transmission in your car, a 401(k) loan can provide the low-cost funds you need, fast. After all, you have access to 50% of your vested balance or up to $50,000, whichever is less. And, you'd be borrowing from yourself, which feels better than borrowing money from the bank.
That's the good news. The bad news is that borrowing from your own retirement plan can lead to bigger financial problems in the future. Here are four mistakes to avoid if you're considering taking a 401(k) loan.
1. Assuming it's the cheapest option
401(k) loans carry a competitive interest rate, usually the prime rate plus one or two percentage points. Using today's prime rate of 5.25%, that equates to a total interest rate of 6.25% to 7.25% -- a far cry from the typical credit card interest rate of 16% to 25%. Plus, you're technically paying the 401(k) loan interest to yourself, not to a bank.
But a 401(k) loan has other financial implications that are easy to overlook. When you borrow out of your retirement plans, your investments are partly cashed out to fund the loan. And that means you're missing out on compound earnings while you repay those funds. If your investments are growing, the cost of those missed earnings could be significant.
2. Delaying retirement savings until the loan is paid off
Most people will lower their 401(k) contributions during the loan repayment period, which can be up to five years. The plan might require you to repay the loan in full before making new contributions, or you might adjust your contribution levels to cover the additional burden of the loan repayment. In either case, when you make lower contributions, it often means lower company-match contributions. And it also means you're delaying your retirement.
Let's say your 401(k) investments are earning a return of 7% annually. If you lower your contributions by $200 a month for five years, you skip about $14,400 in savings. You can't just recoup that balance by adding $200 to your contributions for the next five years, either. Doing that would get you back to the $14,400 -- but if you had left all the money invested and continued contributing for 10 years, you'd have $34,820.
If the plan prohibits you from contributing during the loan repayment period, open up a traditional IRA and save money there instead. You can contribute up to $6,000 annually, or $7,000 if you're over age 50. Depending on your income level, you may or may not get a tax deduction for those contributions, but your IRA earnings will grow tax-free either way.
3. Using the loan to keep overspending
Debt consolidation is a tricky thing. You pay off various high-rate cards to lower your monthly burden and shorten the debt payoff period. But then you end up with available credit on the accounts you've just repaid. You'll be in a very bad place financially if you give in to the urge to use those newly repaid credit cards.
Avoid that fate by chopping up the card or hiding it away somewhere. Don't close out the card entirely, because your credit score will take a hit -- just do what it takes to stop using it. Then, put yourself on a budget and stick to it by paying cash whenever possible.
4. Not evaluating your job security before taking out the loan
If you lose or leave your job, you'll have to repay the loan to avoid a tax penalty. The good news is that you have until your next federal filing date, usually April 15, to complete the repayment. But if that date comes and goes, and you're younger than 59 1/2, the unpaid loan is treated as a taxable distribution and taxed at your federal income tax rate plus an additional 10%.
Note that you still owe the money if you roll over your 401(k) balance to an IRA after you leave your job. The only way to sidestep the taxes is to make an IRA contribution equal to the outstanding loan balance.
The takeaway here is to evaluate your job security before borrowing from your 401(k). If you have any doubt about staying in your job, look at other sources for the cash you need.
Keep saving if you do borrow
Tapping your 401(k) for a loan might seem like a good idea on paper, thanks to a low interest rate and easy access to the funds. But there are trade-offs. The disruption to your retirement savings plan can be hard to overcome, and you face a big tax penalty if you lose your job. Think through those possibilities and limit the downsides by committing to increased retirement savings going forward.