Financial advisors typically discourage their clients from taking out a loan on their 401(k) plans. Eric Meermann of Palisades Hudson Group explains under what circumstances this option is actually a good idea. Continue below for more information on borrowing from your 401(k).
Emergencies like natural disasters are prime opportunities to borrow from your 401(k)
If you ask a financial planner if you should borrow from your 401(k), they will most likely respond with a firm no. I’m not one of those financial planners.
Let’s say you need to make a down payment or pay a high-interest debt. For serious purposes like these, borrowing from your 401(k) is a viable option as long as you’re sure you can pay off the loan.
Surprise expenses happen, like flood damage in the wake of a devastating hurricane like Irma or Harvey. In cases like these, a loan is a smarter move than accumulating credit card debt.
Unlike other loans, borrowing from a 401(k) or another retirement plan allows you to avoid lenders. Under the condition you pay back the loan on time, you can instead access your account without paying tax or penalties.
You pay yourself, so interest won’t disappear into a lender’s pockets. Think of this move as like buying a bond. You may even achieve a higher yield than you would by investing in bonds in your account.
You can borrow — under most circumstances — up to 50 percent of your account balance or $50,000, whichever is less. And although regulations specify a 5-year repayment schedule, you can always pay off the loan sooner.
Loans used to purchase a primary residence may be paid back over a longer time, typically up to 15 years. Payments usually come directly out of your paycheck on an after-tax basis. Your plan determines the interest rate, based on prevailing interest rates.
Another point to consider before taking a loan is your job security. If you still owe money when you leave your job, you will need to repay the balance in full within a short grace period, usually 60 to 90 days.
If you fail to repay the loan on time, it will be treated as an early distribution — meaning it will become taxable and subject to a 10 percent early withdrawal penalty if you are under the age of 59.
You will owe a substantial sum not to yourself, but to the Internal Revenue Service.
Anyone should consider the other drawbacks before taking a loan.
First, there is the opportunity cost. If you’re mainly invested in stocks, the average annual expected return hovers around 10 percent — more than the typical interest rate on borrowing from your 401(k), currently around 3 percent.
The opportunity-cost objection assumes the stock market will always rise. That’s true over the long term, but you can actually increase your wealth if the market happens to dip while your 401(k) loan is outstanding. The objection to borrowing on the grounds of missing potential gains ignores the potential for losses over short periods.
Another drawback, is when borrowing from a traditional 401(k), you withdraw pre-tax money and repay it with after-tax money.
So, before taking a 401(k) loan, look to other funding sources first. If you’re a homeowner, you might consider a low-rate tax-deductible home equity line of credit. Other sources might be an intrafamily loan or a loan from friends.
When It Makes Sense
But absent other good choices, a loan can be the best solution. For instance, it can make sense for people who are retirement-fund rich. That’s someone with a good salary, little taxable money, significant retirement savings and big debt.
That description fit me several years ago, so I used a loan from my profit-sharing plan to jump-start my efforts to pay down my 6-figure student loan debt (A profit-sharing retirement plan is different from a 401(k), but the loan worked the same way.)
I used the money to pay down a significant portion of the principal, which shortened the term of this loan as I continued to make the normal monthly payments. Instead of paying a high rate to the lenders, I paid myself at a lower rate.
This strategy only works if you have the cash flow to support both loan payments, but if you can handle it, it can save you money because you’ll pay off your debt faster.
Another good reason is to help finance the purchase of a home, especially a first home. For example, the 1-bedroom apartment that was fine for a young married couple may abruptly become unworkable when the couple gives birth to twins. Taking out a 401(k) loan is probably better than waiting years while you save up for a down payment.
Retiring high-interest credit card debt is another possible use for a 401(k) loan.
If you accumulated this debt due to an unusual event, such as a major medical expense, it can make sense to pay it off once with a 401(k) loan. But if your credit card debt is the result of profligate spending, ask yourself if you’ve truly changed your ways before you even think about touching your retirement account.
Similarly, if you’re hit with a major unexpected expense, the ideal scenario would be to cover it with an emergency fund. If your savings cannot cover the cost, however, a 401(k) loan could prevent you from incurring high-interest credit card debt instead.
While borrowing from your 401(k) shouldn’t be your first resort, it can be a good move.
As with any major financial decision, you will need to balance your goals with the potential risks and decide whether the approach is right for you.
Eric Meermann, Certified Financial Planner (CFP), Enrolled Agent (EA), is vice president of Palisades Hudson Financial Group in Stamford, Connecticut. Palisades Hudson Financial Group is a fee-only financial planning firm and investment manager based Fort Lauderdale, Florida, with more than $1.3 billion under management. It offers financial planning, wealth management, and tax services. Its Entertainment and Sports Team serves entertainers and professional athletes. Branch offices are in Stamford, Connecticut; Atlanta, Georgia; Portland, Oregon; and Austin, Texas.The firm’s monthly newsletter covering financial planning, taxes and investing is online at www.palisadeshudson.com/insights/sentinel. Sign up to receive articles by email at www.palisadeshudson.com/get-sentinel.Social media: Twitter; LinkedIn; Facebook; Instagram.
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