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Pros and Cons of 401(k) Loans

Couple discusses the benefits and risks of withdrawing money from their 401k retirement account to cover major expenses.

The likelihood that you will need to cover a major expense or live off savings during your working life is extremely high, according to research by The New School. The study found that:

  • Ninety-six percent of American men experience a 10 percent drop in their annual earnings at least four times in their working lives.
  • Sixty-one percent of American male workers age 25 to 70 report at least one episode of losing work earnings for an entire year.
  • By age 70, 1 in 4 male workers reports having four or more episodes of no work earnings for at least a year.

Women are even more likely to lose earnings due to caregiving. Sixty percent of caregivers are women, according to an AARP study. The more time spent caring for children and other relatives, the harder it is to work and build up savings.

Some major expenses can be anticipated, but that doesn’t mean they’re easy to save for. Housing and medical expenses are common reasons to tap a 401(k) or similar retirement account. Many Americans live paycheck to paycheck, and their retirement accounts often are their largest source of funds.

Since you repay yourself — plus interest — right back into your own 401(k), tapping a retirement account is worth considering in certain circumstances. It’s best to check with a financial advisor before making any major decisions.

What’s So Great About a 401(k)?

For one thing, payroll deductions make saving for retirement a lot easier. You often don’t even miss the money. It’s a huge advantage that your employer saves you the time and headache of setting up your own investment account.

Then there are matching contributions — the “free money” of retirement saving. Employers who offer a match usually contribute up to a certain percentage. If you’re wondering how much to contribute to your 401(k), start with at least the matching contribution. If your employer will match up to 3 percent, then contribute at least 3 percent.

401(k) Loans

Probably the most important aspect of a 401(k), 403(b) or 457 account is the ability to contribute pretax money.

If you borrow from your 401(k), this money no longer will be earning interest. So, you not only lose out on the money itself, but also the potential interest it could have earned. If that money might have earned a 10 percent return, you would have to replace 110 percent to break even on the loan.

You usually repay the loan through payroll deductions, the same way you make contributions. But your loan payments are not tax-deferred, so you are repaying with after-tax money. You’ll be taxed again when you start taking withdrawals in retirement. Some discourage 401(k) loans because of this double tax hit.

Not every 401(k) plan allows for loans, but those that do are governed by federal regulations:

  • You can borrow up to $50,000, or half of your account balance, whichever is less.
  • If you leave the job and fail to repay the loan balance plus interest within 60 days, it is considered a distribution, which triggers taxes at your typical rate and a 10 percent penalty if you are younger than 59 ½.
  • 401(k) loans must be repaid within five years.
  • The interest rate and terms are determined by your specific plan.

401(k) Loan Risks

Even if you’re sure you can afford to repay the loan within five years, beware of the unexpected. The biggest risk is that you leave your job before your loan is repaid. What would happen if you were laid off in two years? Would you be able to pay back the loan plus interest? If not, any remaining balance would be taxed and you would be penalized.

Then, of course, there is the lost money for retirement. Every dollar that you can keep in your 401(k) helps grow your nest egg. It’s important to weigh these risks in relation to the purpose for borrowing the money. If you don’t really need the loan, it’s best not to take unnecessary risks.

Hardship Withdrawals

Hardship withdrawals are an option if you don’t want to take a loan and you meet the requirements. Hardship is defined by the Internal Revenue Service (IRS) as an “immediate and heavy” financial need for the purpose of:

  • Some types of medical expenses
  • A down payment on a primary residence
  • Money needed to prevent eviction or foreclosure from a primary residence
  • Certain repairs to your primary residence
  • Funeral expenses

The financial need doesn’t have to belong to you. It could belong to a spouse, dependent or beneficiary. The need is not considered immediate and heavy if you have other financial sources to cover it. You may not take a withdrawal for more than what’s needed, but you can take out enough to cover taxes. And you will pay taxes on hardship withdrawals — however, the 10 percent penalty is waived. You are prohibited from contributing to your 401(k) for six months after taking a hardship withdrawal.

If you’re facing a heavy financial burden, borrowing or withdrawing from a retirement plan can be useful. Just be sure you’ve considered the potential risks and consequences. Look for the option that lets you keep as much of your money as possible.

[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by National Endowment for Financial Education.]

Ver este artículo en espanol: Ventajas y desventajas de sacar préstamos de tu cuenta 401(k)