According to the National Bureau of Economic Research, in 2015, 20 percent of Americans have an outstanding loan balance on their 401(k) and 37 percent have had loans in the past five years.
Ten percent of those borrowers defaulted and a whopping 86 percent of borrowers left their company with an outstanding balance, according to that report.
And all this comes despite the fact that many financial advisors recommend strongly against taking out loans against in your 401(k).
Why do people do it anyway. Because it’s easy, says financial planners.
“I don’t think it’s a good idea to do that unless it’s a dire emergency,” says Brian Singer, of Singer Investment Group in Bloomberg, Ind. “We have this Golden Rule in the financial world that says when you save for retirement you have to pay yourself first. That violates that rule.”
“If you take money out of 401(k) it’s a little bit of a red flag,” he says. “If that’s where you need to go for the money, you might be living beyond your means. I’d rather see someone, if they have to do that, consider a home equity loan.”
Jeremy Keating, financial advisor at Capital Income Advisors in San Diego, says the topic comes up often with his clients.
“There are two different sides,” he says. “The first thing I hear from clients is ‘I pay myself back.’ It’s is true. But the whole point of a 401(k) and IRA is to save for long-term retirement. The times you should dip into that are little. You are paying yourself back, but if you have $50,000 and take $10,000 (for a loan), you take compound interest off the table and you are getting interest on only $40,000.”
“There are a lot of reason to think two or three times before your borrow money from your 401(k),” says Singer. A few of the other reasons:
- Borrowers often stop or reduce their contributions to a 401(k) after a loan, further reducing their retirement savings.
- If you leave your job, you will have to repay the loan or suffer the consequences – both taxes and penalties. “If you get into a pinch and cannot repay that loan and new job opportunities comes up, that (loan) is fully taxable depending on age and early withdrawal penalty,” Singer says. “You get into a lot of new areas you have to be cautious of.”
- Your 401(k) money will be taxed twice, says Singer. How so? Think of it this way, you repay the loan with after-tax money. And later, when you withdraw your 401(k) money in retirement, you pay taxes on the funds you withdraw, making it a “second” point of taxation.
“People who would be in favor of (borrowing from their 401(k) would say that is a less expensive way to borrow money, and you are paying yourself back. But, when you talk about paying yourself back, you have to always acknowledge that you are paying yourself back with after tax money.”
- People who borrow from their 401(k) are more likely to borrow again, according to Fidelity Investments.
“People do it because it’s easy,” says Keating. They do the math and calculate they are paying a low interest rate as opposed to higher interest loan. It’s cheaper than high-interest loan. But its more than that. It’s also about the compound interest. As soon as you miss that first day at gym, what happens to your discipline? It goes downhill. It is easier to miss the second day. It’s the same thing with 401(k) (when you stop contributing).
“You also don’t get a (tax) write-off,” he says. “If you get home equity line, you can write that off. That’s where people, if you use the calculator and do the math, forget about those other things.”
Both Singer and Keating say the fact that you have borrow indicates larger problems with your finances.
The bigger issue is the behavior,” Keating says. “Even if the math supports it, I don’t believe you should take it. It is so much easier (with a 401(k) loan) to not pay off your loan. If you don’t, your credit score doesn’t goes down. It will become a taxable distribution. But nobody cares about that.”
“There is not enough to deter them,” Keating says. “If you take it from somewhere else, you have to pay it back. The 401(k) is easy come, easy go. If it’s too easily for them to get, they don’t have as much as a reason to pay it back.”
“If you don’t have other options or alternatives, if that’s the only place to go for that loan and for that money, I guess you do what you have to do,” Singer says. “But I think you are setting yourself up to regret that later on or get into trouble later on.”
“Someone asking my opinion I would discourage them from doing that,” he says. “It defeats the purpose.”
This article is for informational purposes only and is not intended to provide any tax or legal advice. We encourage you to speak with a qualified tax advisor regarding your specific situation prior to making a financial decision.