It can be tempting. You spend years and years building up a stockpile of money that just sits in an account and doesn’t seem to do anything for you in the present. Sure you know your savings is for retirement. But that seems so far away. What about my problems and needs for today? Can I borrow against my 401k and use the money to tide me over for a little while?
This line of thinking is exactly the rationale that gets many people into trouble with their retirement savings. Sometimes when you’ve got a decent chunk of money stashed away in your IRA or 401k, it can be very tempting to think that you should be able to help yourself to even a small portion of it if needed.
The IRS recognizes this too. Although your employer can restrict the terms of the loan, they do have to be reasonably available to all participants of the retirement plan. Some of the common reasons people decide to borrow against their 401k include:
- Paying for education expenses
- Preventing eviction
- Medical expenses
- Buying your first-time home
Can I Borrow Against My 401k – Not If You Want to Succeed:
While borrowing from your 401k can be tempting, there is one major setback that you should strongly consider:
- It will reduce the overall growth potential of your entire balance.
Let’s look at a simple example: Say you’ve got two employees that are exactly the same. They both contribute $6,000 to their 401k balance (same funds), and it grows at an average annualized rate of 8% each year.
But the two employees treat their accounts differently. Employee A simply continues at the normal pace of adding a $6,000 per year contribution to his 401k plan.
Employee B decides around Year 11 to borrow $40,000 for a home purchase. You are allowed to borrow up to 50% of your vested balance with an upper limit of $50,000. If you’ve already borrowed money within the past 12 months, then the balance of the loan will be subtracted from your allowable amount.
The loan generally needs to be paid pack within five years, although you can usually get this term extended if the purpose was for a house. Employee B now has to put $8,000 per year back into his plan (plus interest and fees). Because of that, he will likely discontinue his original $6,000 contributions to cover the new $8,000 payments he has to pay back to his 401k plan. At the end of five years when the loan is paid back, he then resumes the $6,000 contributions.
So how much more money does Employee A have over Employee B after 30 years?
As you can see, when your balance dips, that cripples the amount of growth potential your balance can experience. As a result, your account will lag behind the path that you could have been on. Even after you repay in full the 401k loan within the five years, the depressed account balance will still have caused a few years of reduced returns.
Alternatives to Borrowing Against Your 401k Plan:
Rather than give into temptation to borrow against your 401k plan, you should try your best to seek to seek other alternatives that won’t sabotage your retirement efforts.
- Save your money until you can buy it. If the goal is far away and you have time to save, then simply budget your money by putting away a small portion each month towards this goal. Once you decide the item is important enough, you’ll be surprised at how quickly you’ll be able to make cuts and start saving towards the item.
- Take out a home equity loan. If you already have a house and need to borrow money very soon, a home equity loan may be a better alternative than borrowing from your 401k plan. Getting the money from your home equity won’t have any effect on your retirement balance, and you can usually take out the home equity loan for longer durations.
- 0% APR balance transfer. If you need the money in a hurry and don’t have a house, another strategy you can use is to open a 0% ARR credit card. This technique is more risky than I usually like to recommend, but it will still achieve the goal of not borrowing against your 401k plan. There is usually no shortage of credit cards offering a 12 month 0% interest period or a balance transfer at 0%.
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Mr. Bonner says
Why do you make the assumption that person B will discontinue the $6000 normal contribution? If you treat it as a normal loan and all other finances remain the same, including your normal 401K contribution, what’s the drawback? My plan has a $75 fee and charges 4.25% interest with the interest going back into my 401K. The only drawbacks I see are the relatively small fee and having a fixed amount of growth on the money I borrow of 4.25%. If the market has a big bull run then the money I borrow will lose out on that, but if the market stays flat or drops then the money borrowed won’t grow anyway.
I think your article is a bit misleading and your example makes a pretty big assumption to try and help prove your point while you don’t really touch on some of the advantages of such a loan.
Understandable that there may be some rare instances where borrowing money from your 401k does have some benefit. However, I highly doubt that if the common person needs to borrow this much money, they will be unable to sustain contributing the same amount as they were before.
Missing out on that bull run is precisely the reason I’m suggesting for people not to go this route. You never know ahead of time when one is going to happen.
I have a question more than a comment. I own a piece of rental property- 4 units- 3 apartments, 1 law office. The mortgage is good at a good fixed 30 yr rate. The insurance has been a nightmare. I had a tenant have a fire in his unit and had a claim less than a year ago and now I can not get insurance anywhere. I bought the building for $100K- borrowed $80K- put down $20K- I have a conforming nice mortgage but my payment is going up by over $350 per month due to my inablity to get any insurance company to cover me- mixed use and prior claim are the reasons they say. I have a great credit score and own other property. Should I borrow from my other properties or take a loan on my 401K to pay off the mortgage so I don’t have to have insurance. My payments are going to increase over $3500 a year which is crazy.
Wow that sounds like a pretty wild situation. Even though I’m not financial planner, if I was in your shoes, the first place I’d look is to see which of your loan options is going to give you the best interest rate. I hate to say it, but its probably going to be the 401k since you get to determine most of the terms. Definitely run the numbers in both cases and make sure you know what the risks are either way you go. I hope you are able to overcome your insurance problem!
I have a scenario regarding borrowing from a 401k that i haven’t seen mentioned. What if, you’re looking to borrower let’s say 20k from your 401k because you think the market will dip hard again this OCtober. Let’s say this turns out to be true and we have a huge crash again. And then the person pays back in full the 20k her borrowed within a few months of taking it out at a much lower cost basis into the same funds. The fee is only $100 to borrower the money so if this scenario played out wouldn’t that person then be much better off?
Yes in that hypothetical situation that would be true. But the market could have just as easily taken a swing upward and the person would have lost out big. Remember this: NO ONE can predict the future. NO ONE can tell you if the market is really going to go up or down tomorrow. To borrow money from your account on speculation like this is highly not advised.