For many people, it’s their biggest pot of money. So when a major expense like an over-the-top car repair or a costly medical emergency arises, it can be a tempting place to turn. But is it always the best solution?
Borrowing from your 401(k) account—assuming it’s allowed by your company’s plan—can seem like an easy way to secure a loan. After all, it’s money you’ve earned and contributed to your account, and of course you’re planning to pay it back. But there can also be drawbacks to borrowing in this way. Before you decide, consider these questions.
What’s the downside of borrowing money from myself?
The opportunity you’ll miss
If you take out a loan, that money isn’t invested in your 401(k) account until you pay it back. So you’ll be missing an opportunity for that money to grow. The more money you leave in your account, the better your chances for a higher account balance when you retire.
- You’ll reduce your take-home pay – Loan payments are made through after-tax payroll deductions (ultimately, any other type of loan would also be paid back with after-tax dollars). This means that until your loan is paid in full, you’ll have to get by on less. Before making the call, be sure to calculate the net effect on your take-home pay.
- You may lose momentum – Because your take-home pay will be reduced, you may need to reduce contributions to your account while your loan is outstanding, depending on your disposable income. In addition, although this is not common, sometimes plan loan policies won’t let you make additional contributions to your account until your loan is paid in full—essentially putting your retirement funding on hold.
- You might face additional taxes – If you lose or leave your job before your loan is paid off, you may be on the hook to pay the loan back in full in a short time period, to prevent it from being treated as a distribution and taxed accordingly. The outstanding amount may be subject to federal and, if applicable, state income taxes, as well as a 10% additional federal tax for early withdrawal if you’re under age 59½ and no exception applies.
- You could miss out on growth – When it comes to investing for a long-term goal like retirement, time truly is money. That’s because your money loses some of its ability to compound, or earn interest. With compounding, the potential to grow includes not just the money you invest, but also what that money earns for you. Taking your money out of the market via a loan might mean missing out on that valuable growth opportunity.
When could it make sense to borrow from my 401(k) account?
Never, in the eyes of some industry experts. After all, while you may have other sources you can turn to for your immediate credit needs, you can’t borrow money for retirement. Still, there are a few circumstances when you may want to think about it.
How plan loans work
Many retirement plans allow you to borrow up to half of your vested 401(k) account balance, or up to $50,000 minus any outstanding loan balance, whichever is less. A general-purpose loan must be repaid within five years, or it will be treated as a taxable distribution. However, a loan used to purchase your primary residence can be paid back over a longer period of time without being treated as a taxable distribution. Be sure to review your plan’s documents for specifics on loan requirements and terms within your plan.
- You need fast access to cash – If you’re in an emergency situation and need money immediately—say, to repair your home after a natural disaster or to deal with an unforeseen medical situation—a loan from your retirement account might be a viable option.
- It helps you out of a bad financial situation – Perhaps borrowing from your 401(k) account enables you to pay off a high-interest credit card, at an interest rate similar to—or potentially less than—the rate you would pay for a bank loan. Because there is no credit check with a retirement plan loan, and you pay the interest to yourself rather than to a bank or credit card company, this might be worth considering.
- You want to make a down payment on a home – A higher down payment could lower the interest rate on your mortgage. Bear in mind that with loans from other lending sources, interest is typically tax-deductible. That’s not the case with a retirement-plan loan.
Do I have other options?
Before you consider taking a loan from your 401(k) account, make sure you’ve exhausted all other options. Not sure where to start? A financial professional can help you understand your choices.
One way to avoid dipping into your retirement account prematurely is to set up an emergency fund. Putting aside a little money every month can give you a source of ready cash whenever an unexpected expense crops up. By thinking of your 401(k) account as your last resort for a loan—and not letting your short-term needs derail your retirement plans—you’ll be doing your future self a big favor.
Neither Merrill Lynch nor any of its affiliates or financial advisors provides legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.