One in three Americans who participate in a retirement plan say they have taken out a loan from the savings in their plan, according to a study by TIAA-CREF. Forty-four percent of people who have borrowed against their retirement plan regret the decision, while an additional 23 percent do not regret taking out the loan, but said they would not do it again in the future. Among those who took out a loan, 43 percent have taken out two or more loans, according to the survey, 2014 Borrowing Against Your Future.
Not all 401(k) plans offer loans, but nearly all large plans (95 percent) allow participants to take at least one loan against their savings, according to Aon Hewitt’s 2013 Trends & Experience in Defined Contribution Plans survey.
Financial advisors, generally, are not fond of 401(k) loans, especially in light of the reasons why workers are borrowing — to make up for not having a financial plan in place or not following the plan – and because these are funds meant to be withdrawn at retirement.
According to TIAA-CREF, 46 percent, of the respondents, borrowed to pay off debt; 35 percent to pay for emergency expenses; 26 percent for a new home or renovation; 24 percent to pay bills due to a job loss; 20 percent for education costs; and 15 percent to pay for special events, such as a wedding or family vacation.
Should you ever borrow from your 401(k) and, if so, when and under what conditions?
Experts say it might be okay to borrow to pay down debt or to pay for emergency expenses, but not without some forethought. For instance, one expert suggests a two-step process to evaluate whether it’s wise to take out a 401(k) loan.
“The first step is asking whether it’s a good idea to spend the money which is causing you to take out a loan,” James Choi, a Yale University professor told USA Today. “If it is a good idea, the second step is asking where the loan should come from, and, very often, it’s going to be the case where a 401(k) loan is more attractive than alternative sources of credit.”
Many people don’t have enough saved for retirement in the first place. When they borrow the money from their 401(k) – typically up to 50 percent of their balance – the money is no longer working for their retirement needs.
In addition, the survey found while borrowing from their 401(k)s, many Americans are contributing less to their plans while paying the loan back. More than half the survey respondents (57 percent) who took out loans decreased their contribution rate during the payback period. Those 18-34 were the most likely to decrease their contribution amount (81 percent). Forty-eight percent of women kept the same contribution rate while paying back the loan, compared to only 39 percent of men.Millennials (81 percent) were the most likely to decrease their contribution amount during the payback period.
Having an adequate emergency fund in reserve is a good way to steer clear of borrowing from your 401(k). What if you’re out of cash and out of options?
“There are certainly situations where it is best to take out a 401(k) loan, for instance when there is a medical emergency and a large expenditure on medical care cannot be covered using other assets,” John Beshears, a Harvard University professor and co-author of a study on the subject, The Availability and Utilization of 401(k) Loans, told USA Today.
However, 401(k) borrowers need to ask themselves, after the emergency has passed, whether they are still on track to achieve their retirement savings objectives and, if not, what adjustments should be made, said Beshears.
“When times are good, it is easy to forget there might be another financial emergency around the corner, and it is when times are good people should put aside a little extra, perhaps in a 401(k) plan with a loan option or perhaps in a non-retirement account, to cover, precisely, those emergency needs,” he said.
Under certain circumstances, borrowing from a 401(k) to purchase a home, finance a business or advance your education might be worth considering. The repayment period is often extended for homebuyers.
Before you tap into your retirement account, however, consider other options: student loans, a home equity line of credit (HELOC) for home renovations, or a loan or withdrawal from a permanent life insurance policy.
Think carefully before taking a loan against your 401(k). There are various tax implications of a 401(k) loan. As you pass-up the tax-free compounding of the money you withdraw, you could end up with a significantly smaller fund on your retirement. Also, interest payments from a 401(k) loan are not tax deductible.
You will also pay taxes twice on the amount you took out for a loan. Your 401(k) loan payments are deducted after taxes have been taken out of your paycheck. Since pre-tax money is usually used to fund a loan, however, the payments are put back into your 401(k) as pre-tax funds. This means, when you take the money out later, you will have to pay taxes on it again.
In addition, you could face the potential of defaulting on your loan. If you lose your job or if you decide to leave your employer, you will be required to pay off the loan in a lump sum. If you don’t, you face the potential of the loan defaulting, which will result in a taxable event.
Finally, there is no flexibility with the terms of repayment and your loan repayment is done automatically through payroll deductions, which will reduce your take-home pay.
When you take a 401(k) loan, you specify the investment account(s) from which you want to borrow money. Those investments are liquidated for the duration of the loan. You lose any positive earnings which would have been produced by those investments for the period of the loan. The upside is you also avoid any investment losses on this money.
Still considering? There are two things you should know. First, there are limits to the amount you can borrow. In general, you can borrow the lesser of $50,000 or one-half of your retirement plan balance. For example, if your 401(k) balance is $200,000, you could only borrow $50,000, not half of your plan balance. To accept the loan, you must typically agree to begin paying back the loan during your next pay period. Most often, this is done via an automatic deduction from your paycheck. During the loan repayment period, if you elect to suspend ongoing contributions to the plan, your future retirement account balance may be further impacted.
Second, unless you use the money to buy a home, you must pay the loan back within five years. If you borrow the money so you can purchase a residence, the length of the loan may be longer.
If you’re considering borrowing from your 401(k), take into account these tips:
Calculate the cost of a loan. Before you take a loan, run this TIAA-CREF calculator to see how much it will cost you in retirement security. Remember, you can borrow up to $50,000 of your vested balance or 50 percent of it, whichever is less. Typically, you have to pay back the loan within five years. If you don’t pay it back, it’s considered a distribution and you’ll owe income tax and the 10 percent early withdrawal penalty if you’re under 59 ½ years old.
Don’t become a serial borrower. Nearly half (47 percent) of the survey respondents who took out a loan, borrowed more than 20 percent of their savings and 9 percent borrowed more than half of their savings.
Keep up regular contributions. If you do take out a retirement plan loan, it’s important to make new contributions to your plan while you’re paying back the loan.
Retirement nest egg vs. summer vacation. While the majority of those surveyed took out loans to pay off debt or for emergencies, some employees are raiding their retirement accounts for reasons like home renovations. Even more troubling: 15 percent of those surveyed said they took out loans to pay for special events, like a wedding or family vacation.
Still not sure what to do? Talk to a independent financial advisor who can help you weigh the pros and cons to borrowing from your 401(k).
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