Borrowing from your 401k is not something to take lightly, Grownups. John Schneider lays out when it’s OK—and when it’s not.
You expected that, right? It’s been engrained in our heads that taking money from our 401ks before retirement is stealing from our future.
However, there are situations when our current lives may require us to borrow from our future lives.
One can almost hear the collective gasps of financial advisors at the thought of someone borrowing from their 401k. They’ll recover, and if we borrow from our 401k, we’ll recover, too—with some effort.
Granted, I don’t advise anyone use their 401k as an ATM. A 401k isn’t a convenient place in which to save money for a rainy day and shouldn’t be used in place of an emergency savings account. It’s a tool that should only be used to save for retirement.
The Difference Between Borrowing and Taking a Distribution from a 401k
Borrowing money from a 401k and withdrawing money from a 401k are different. Borrowing means we intend to pay it back. Withdrawing, or taking a distribution, means the money never returns to the 401k.
It’s up to each company to determine whether they’ll allow their 401k plan participants to borrow from their 401k. If the company allows for borrowing, the Internal Revenue Service (IRS) restricts the borrowing up to the lesser of $50,000 or 50 percent of a 401k account balance. The IRS also requires that the loan be paid back within five years or before voluntarily or involuntarily leaving the employer that sponsors the 401K plan. If a payment isn’t made within 90 days, the IRS itemizes the money withdrawn as a 401K distribution that is taxed at the account holder’s tax rate, plus a 10 percent penalty if they’re under the age of 59 and a half. This tax and penalty are two things that can add tens of thousands of dollars to a tax bill.
When You Should Not Borrow from a 401k
I think it’s best to start the conversation with when it’s not OK to borrow from a 401k. Robbing future financial security should never be done for the sake of today’s wants. The list below is not exhaustive. There are other circumstances when borrowing from a 401k shouldn’t happen, but you’ll get the picture.
- Paying Off Debt: How was the debt acquired in the first place? Was it obtained by spending less than earned? Will our habits change if the debt is paid off? (Probably not.) Until there is a proven track record of not using credit cards to outlive our income, it’s best not to borrow from a 401k to pay off debt.
- Buying a First Home: Many Millennials have put off buying homes because of debt and mobility, but when the time comes, we shouldn’t rush it by borrowing from a 401k. The delays of saving for the down payment may seem minimal compared to what’s gained from possible 401k investment earnings.
- Buying a Bigger Home: Let’s all stop trying to keep up with the Joneses. Considering that, we need to ask ourselves if a bigger home is necessary. After the credit crisis, planning and saving for a home has proven to be the best way to buy a dream home.
- Taking a Vacation: Contrary to our banker’s advice to apply for a Home Equity Loan (HELOC) to go on a dream vacation, this is never a good reason to borrow from a 401k or apply for a HELOC.
- Paying for Education: Whether it’s for us or our children, borrowing from a 401k to pay for education is a mistake. As we’ve seen recently, more education doesn’t always result in a better-paying job.
When Borrowing from a 401k May Make Sense
The following are scenarios (real needs versus wants) when borrowing from a 401k may make sense.
- Medical Emergency: Our health is our most important commodity. If the need arises (and all other options have been exhausted), it may make sense to borrow from a 401k for a medical or life-saving emergency.
- Home Foreclosure: Losing a home is a financial setback—keeping a home can be one, too. If we risk losing our home, it may be a good idea to downsize. To retain equity to use for the purchase of a cheaper home, it may make sense to borrow temporarily from our 401k.
- Job Loss: This would only apply to the job loss of a spouse—one can’t borrow from their 401k once they’re no longer employed and a part of the 401k plan. Borrowing for necessities only, after emergency savings have been used up, may help cover needs until our spouse returns to work.
What Does Borrowing from a 401k Really Cost?
Here are two hypothetical examples of people looking to borrow $25,000 from their 401ks.
Grownup One borrows $25,000 from their 401k and pays it back over five years at a hypothetical rate of 4 percent. Three things to keep in mind about the loan repayment, the money is not matched by the employer, the loan repayment does not count towards annual contributions, but it does grow (in this scenario, at a hypothetical 7 percent) annually. Twenty-five years later, Grownup One’s net savings and investment growth from the $25,000 is roughly $123,800*.
Grownup Two decides not to borrow $25,000 from their 401k and earns the same hypothetical 7 percent return on the $25,000 invested in the market the whole time. Twenty-five years later, Grownup Two’s $25,000 increased to $135,700*.
The difference of $12,000 may not seem like much, but considering the median retirement savings per retiree older than 50 is only $135,000, that’s nearly 10 percent of a retirement nest egg.
To Borrow or Not to Borrow
Ultimately the decision is up to the individual; each situation is unique.
I’ll say, though, after paying off $51,000 in credit card debt and amassing nearly half a million in retirement savings, David and I encourage everyone to dig deep and consider other options before borrowing from their future to pay the present.
Read more stories from John Schneider and David Auten at DebtFreeGuys.com.
*These figures are hypothetical and actual returns can be higher or lower, and there is no assurance any particular rate will be achieved. Variations in returns, contributions, withdrawals and other factors will affect your total earnings.
While we hope the information in this article is useful, it may not reflect the opinions of SoG, and it is not intended as legal, tax, or investment advice, and may not apply or be useful to your specific financial situation. If you need recommendations geared to your personal financial situation, consider scheduling time with a financial planner.