What’s more, whatever money you take out doesn’t get the chance to grow at a compounding rate — a move that could cripple your portfolio down the road.
“The long-term consequences of that are going to be very painful,” Anne Lester, a retirement expert and author of new book “Your Best Financial Life: Save Smart Now for the Future You Want,” recently told CNBC Make It.
But what about a loan? After all, you’re effectively borrowing your own money and paying yourself back, with interest. In a narrow set of circumstances, it can be a smart financial move, says Jared Friedman, a certified financial planner and partner at Redwood Financial Planning in Scotch Plains, New Jersey.
But tread carefully. “We typically recommend it only as a last resort,” Friedman says.
The specifics of a 401(k) loan will vary from employer to employer, but here’s how they generally work.
You can typically borrow up to $50,000 or 50% of the vested balance in your account — whichever is less. From there, you’ll have a set amount of time — commonly five years, but more if you use the loan to fund a home purchase — to pay the loan back via regular, equal-sized payments. You can, however, pay the loan back ahead of schedule without penalty.
Like most loans, you’ll be charged a rate of interest. In this case, that’s often 1% or 2% plus the prime rate, which is the rate at which banks lend to their most creditworthy customers, currently 8.5%. Unlike other loans, though, interest isn’t going into the hands of an outside lender, but rather, right back into the balance of your 401(k) account.
Because you’re not dealing with a lender, borrowing from your own 401(k) doesn’t affect your credit score, nor do you need to undergo a credit check to get one.
There are some costs and inefficiencies associated with these loans. Some plan administrators will charge an origination fee for taking the loan and may tack an annual fee on top for each year you haven’t paid off the balance in full.
And while money in your 401(k) is put in pre-tax, the money you pay back is in post-tax dollars. Any money you then withdraw in retirement is subject to income tax, too — meaning you effectively pay taxes twice.
If you’re unable to pay the loan back, it converts into a distribution, meaning you’ll owe income tax, plus a 10% penalty on your outstanding balance. Leave your job or retire with the loan still outstanding, and you’re on the hook for the entire balance. If you can’t pay it off then and there, the balance gets converted into a withdrawal.
It’s easy to see why taking out such a loan can be an appealing option. They come with lower interest rates than you’re likely to get from a personal loan, and significantly lower rates than putting debt on a credit card. Plus, instead of paying the bank, you’re paying yourself — what could it hurt?
The main argument against the loans is opportunity cost. “You’re kind of borrowing from your future,” says Friedman. “You’re pulling money from an account that has investable growth.”
For as long as money is missing from your account, you are missing out on the potential for compounding growth in your portfolio. On top of that, you may not be making regular contributions to your retirement account while the loan is still outstanding if you’re strapped for cash, or by rule in some cases.
“You risk future earnings in order to resolve a present problem,” says Andrew Herzog, a CFP and associate wealth manager at The Watchman Group in Plano, Texas. “Be careful not to completely sacrifice the future to solve a problem today.”
Even if you’re confident you can pay yourself back in full under the terms of the loan, how confident are you that you’ll remain at your current job until everything is paid back?
“The biggest risk is what can happen when you part from your employer with an outstanding 401(k) loan,” says Carla Adams, a CFP and founder of Ametrine Wealth in Lake Orion, Michigan.
To avoid the pitfalls, only take a 401(k) loan under a very specific set of circumstances, experts say. If you need the money for a short-term quantifiable reason, are confident you can pay it back quickly and are certain you’re going to remain employed for the life of the loan, it might be a good option, says Kevin Brady, a CFP and vice president at Wealthspire Advisors in New York City.
“The best example is to supplement a down payment on a new home when the prior home is still under contract for sale or has not sold yet,” he says.
In other words, consider this move only if it’s a short-term bridge loan. But your retirement savings should be far from the first place you go to access cash in a pinch.
“Our goal is to build an emergency cash reserve and treat the 401(k) as a last resort,” says Friedman. “Under the right circumstances, it can be a great tool. But we want to build all of these other tools ahead of it.”
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