If you have high interest credit card debt, want to buy a new car, or simply need some extra cash it is often very easy to dip into your 401k by using a 401k loan. There are no credit checks, the interest rate is low, and the process simple. But is it a good idea? While a 401k loan can bridge tough times or consolidate debt at a lower rate it can also damage your retirement and be a tax trap that results in additional taxes that otherwise could have been avoided. As with many issues in finance there are both risks and benefits to the 401k loan. In this article we’ll explore these issues so that you can decide whether a 401k loan is the right decision for you.
The argument for a 401k loan
The arguments for taking out a 401k loan go something like this, “you are paying interest to yourself so it is better than going to the bank” and “you get a much lower rate than using the credit card”. Both statements are true but also need some clarification. When you take out a 401k loan you must repay the loan plus interest back into the 401k. While it is true that you are ‘paying yourself’ you are also ‘borrowing from yourself’ and the money you borrow can no longer be earning money for you in other investments. The result can be lower returns that hurt your retirement. Secondly, it is true that you may get a better interest rate through your 401k, but not always, and it pays to shop around. For example, home equity line of credit, and auto loans currently have rates that are as low as or lower than most 401k plans.
The argument against a 401k loan
Of course, the biggest reason for not taking out a 401k loan are the tax implications of non-repayment. If you fail to repay your 401k loan the balance of the loan becomes a taxable distribution subject to regular income tax plus an additional federal penalty of 10%. The distribution will be added to existing income, which often results in the distribution being taxed in the higher brackets and can easily result in total tax rates of 50%. Of course, most people never intend to default on their 401k loan, but about 10% of Americans do. More disturbing about 86% of Americans who change jobs default on their 401k loan during the job transition.
The second reason to not to take out a 401k loan is that you are eating into your retirement savings. While only 10% of Americans default on their 401k, the amount of the default is 30% to 40% of the total contributions! For example, if you contribute $10,000 per year to your 401k each year for 10 years, then take out a $30,000 loan to buy a car and default on that loan, you’ve just eaten through 30% of what you have saved for retirement over the past 10 years. It happens over and over in again despite best intentions.
Things to consider
The important message is to be careful with 401k loans. They may be easy but don’t take them lightly. As with any debt carefully consider whether you can easily repay the loan, and make sure that you are not taking out more debt to solve a spending problem. It is best to solve the spending problem first and make sure that the budget is under control before refinancing debt. Also consider your job security. If you lose your job a 401k loan will often become due immediately and leave you with a massive tax bill.
If your budget is under control, and you are still stuck with an 18% bank loan or credit card, then a 401k may be an appropriate, but weigh your situation carefully before you act. Of course, we are available to walk through your situation. Simply give us a call.