Getting a loan can be a real hassle, with most financial institutions making you fill out voluminous paperwork and submit to credit checks and other inquiries. That can make borrowing against the balance of your 401(k) or other retirement plan account look extremely attractive. Before you do so, though, it's essential to consider not only the costs of this financing alternative, but also the potential problems it can entail, like taxes and penalties on the amount you withdraw from your 401(k) in your loan. By running the numbers, you can get a better sense of whether taking a 401(k) loan is really a good idea.
The pros of retirement plan loans
There are three key advantages that retirement plan loans have over regular loans. First, they're a lot easier to get. Typically, all it takes to get a 401(k) loan is filling out a one- or two-page form that your HR department at work will provide for you. You don't have to explain what you want to use the money for, and there's no requirement for a credit check or any other investigation. You can typically borrow up to half of your 401(k) plan balance, up to a maximum of $50,000, although particular employer plans can set lower limits if they choose.
The other really big advantage to 401(k) loans is that their repayment terms tend to be extremely attractive. Remember, any interest you pay goes to you, with the total payment going back into your 401(k) account. Your employer has no incentive to charge more than necessary, and that gives you access to lower rates than you're likely to find anywhere else.
Finally, an additional small benefit of 401(k) loans is that they're easy to repay. Your employer just takes your loan repayment out of your paycheck every pay period, gradually paying down your outstanding balance. You never have to worry about late charges or missed payments, because they come straight out of your pay; you never even see the money.
The downsides of retirement plan loans
However, there are some negatives to borrowing from your retirement plan. The first is that when you take money out of your 401(k), you lose the investment growth that the loan principal would have generated if you had left it in the account. Even though the interest you pay back will boost your balance somewhat, the long-term average returns on investments are higher, and even worse, you have to use after-tax money to pay that interest, even though it will potentially be subject to tax again at retirement.
Potentially even more dangerous is the fact that a 401(k) loan is tied to your employer and your current job. If you quit, get laid off, or retire, then your 401(k) loan will immediately come due, giving you just 90 days to repay the entire principal balance. If you can't, then the IRS will treat you as if you had made a withdrawal from your retirement plan. That typically means you'll have to pay taxes on the amount of the loan that you couldn't repay, as well as penalties if you haven't yet reached age 59-1/2 and don't qualify for an exception to the penalty rules.
Comparing advantages and disadvantages
In assessing whether you should take a retirement plan loan, a number of factors come into play, including what you intend to use the money for, the return on investment within your retirement plan, and your tax rate. The following calculator can help you run the numbers to see where you stand.
Editor's note: The following language is provided by CalcXML, which built the calculator below.
To see how this works, let's start with a basic example. Say that you're looking at taking a $10,000 loan from your 401(k) to pay off credit card debt that charges you 20%. The 401(k) loan has a 6% interest rate, and your 401(k) investments offer an 8% average annual return. You're in the 25% tax bracket, you're 20 years from retirement, and you'll repay your loan over five years.
When you run the numbers through the calculator, you'll see that as long as you keep your job throughout the five-year period during which you're repaying your loan, using the low-rate 401(k) loan to pay off the high-rate credit card debt could be a big saver, even when you consider the opportunity costs of missing out on investment gains during the loan term. In fact, the calculator recommends that you invest the savings back into your retirement plan, suggesting that by doing so, you could boost your overall plan balance at retirement by more than $14,500.
Borrowing from your retirement plan can be a smart move, but you need to consider all the potential positives and negatives. Doing so will let you make a more informed choice about whether to tap your retirement account for a loan.