The advisability of taking a loan from a 401k plan account is always a facts-and-circumstances determination. And like any tax-related decision that affects retirement success, it can get very complicated. So my first advice to anyone seriously contemplating this move is to get professional help from an accountant and/or financial advisor. Questions like these make it a good idea to have one or the other to turn to.
- Perceived financial urgency is the reason most people resort to their pre-tax 401k savings. Needing money for an emergency or an economic opportunity seen as time-sensitive, with no other resources conveniently available, is the driving motivation for most people. It’s almost always better to use after-tax savings for such contingencies, but if there aren’t enough—or any—the situation leaves little choice. The first proposition to test is whether the perception of urgency matches reality.
- The biggest advantages of using the 401k account include relative ease of access ( if the plan’s provisions even permit loans usually up to half the vested balance with a max of $50,000, it’s not a given although most do) and interest rates of prime plus one (tough to beat at a bank or on a credit card balance!). Borrowers can also find solace in the idea that they are paying interest to themselves.
- The reality of the loan’s full potential effects are more complicated. The regulatory five-year payback terms have to be honored; if the loan defaults income taxes become payable on the unpaid balance and if the borrower is under 59-1/2 at the time of default a 10% premature withdrawal penalty can take an additional bite. If you change employer or get laid off during the five-year payback, the loan balance becomes fully payable within 60 days. And even when the terms of the payback are fully honored, you’re using newly-earned after-tax dollars to repay a loan of pre-tax money that you will be taxed on AGAIN when you withdraw the funds in retirement. In other words, you’re turning tax-deductible dollars into doubly-taxed dollars (surprise!) so you should have a really compelling reason to do it. Not to say they don’t sometimes come into play.
- Savers who withdraw money from their 401k accounts are also losing exposure to the long-term return potential of stocks and bonds. Depending on the investor’s time horizon, that could impose a tangible opportunity cost, especially on younger plan participants who can theoretically better tolerate market volatility. The long-term impact of reduced returns can have a devastating impact on accumulation objectives. As they say, investing success isn’t based on “timing” the market but “time in” the market. Missing exposure to a bull-market phase of a full market cycle can leave a long-lasting deficit the full effects of which won’t be apparent until actual retirement.
- Tax rates are always changing and are very unpredictable. Logically, you want to contribute to your employer plan when tax rates are high, to legally avoid them, and withdraw the money you’ve accumulated when tax rates are low, to end up with more spendable income. The current tax regime has lowered tax rates for most Americans. Who knows what the rates will be decades in future. The best general advice may be not to rock the boat unless the urgency you perceive is very real and you have no alternative.