2020 was tough. If you felt the pinch, you might be thinking about pulling some money out of your retirement fund.
Years ago, one of my relatives borrowed money from his 401(k) to move to a new house. Even back then (I was in college), I thought, “That doesn’t sound like a great idea.” And it wasn’t… because he never paid back the loan. He owed a mountain of taxes on a “loan” that swiftly turned into a withdrawal.
I tell you this story because it taught me a valuable lesson. So for those thinking about borrowing from their 401(k)? Two things to note:
- Borrowing money from your retirement fund presents some risk; and
- When faced with a money shortage, you might not think you have any other options.
Let’s take a look at some of the potential pitfalls.
Risks of Borrowing Money from Your 401(k)
If you wanted to, you could call up your company’s HR office right now and ask to take a loan out of your retirement fund, which you must pay back within five years. But that decision comes with some serious strings.
Risk 1: Double taxation
One of the biggest arguments against taking a loan from your retirement plan? The amount you repay in interest ends up double taxed. When you make your loan repayments, including the interest, you use money that’s already been taxed. That’s on top of the taxes you pay when you withdraw from your retirement account. Double whammy.
Risk 2: You’ll have to pay it back more quickly if you leave your job
If you change jobs, quit or get fired, you’ll have to repay your balance sooner than that five year period. That being said, you would have until the due date of your federal income tax return to repay the amount you borrowed from your 401(k).
Risk 3: Your money will grow more slowly
Even though you’ll pay yourself back, you’re still removing money from your retirement account and thus preventing that money from growing. The less money you have in your plan, the less that amount can grow using compound interest. Five years is a long time to lose out on the minor miracle of compounding interest.
Risk 4: It might turn into a withdrawal
What happens if you don’t pay back the money you borrow? Your workplace retirement loan could turn into an early withdrawal. If you’re younger than the age of 59½, you’ll have to pay income tax on that amount, plus a hefty additional 10% penalty on the outstanding loan balance.
Risk 5: You might not have the opportunity to borrow from your plan
Some employers won’t allow their employees to take out a retirement loan at all. Check with your plan administrator or look at its website to see whether you can use this as an option. Don’t rely on a retirement loan as your only option in a financial bind, because it might not even be an avenue available to you.
If You Must Borrow From Your Retirement Fund, Take These Steps
If you have absolutely no other choice and absolutely must borrow from your retirement plan, take these steps.
Step 1: Figure out how much money you need
You want to take out only what you need, because again, you set yourself up for some risks, including the fact that you will never get the compounded interest back — ever. So if you only need $9,000, don’t take out $12,000 “just in case.”
Step 2: Visit your company’s HR department
Visit your human resources (HR) department and inquire about borrowing against your retirement plan. Ask about specific details. In some cases, you can only borrow from your own vested balance. Other companies will let you borrow from both the vested balance and the company match.
Step 3: Learn the repayment details
Again, you must pay this money back within five years. You can do that via automatic deductions. Find out how much interest you must pay on the loan. Your plan administrator usually calculates the interest rate by adding one or two percentage points to the current prime rate. The interest you pay gets added to your 401(k) account.
Step 4: Borrow and pay back your loan
The only thing you have left to do is pay off your loan once you actually decide to take the loan and fill out the paperwork. It’s worth noting that the CARES Act allowed plan sponsors to give you up to an additional year to pay off your 401(k) loans as long as you qualify.
Alternative Ways to Get Money
Want to consider your alternatives, rather than a 401(k) loan? Take a look at these two options instead.
Alternative 1: Tap into your savings
It’s why you have a savings account, right? It’s time to tap into that money instead of borrowing from your retirement account. In fact, if you have this option, take advantage of it.
Experts suggest keeping three to six months’ worth of necessary monthly expenses in your savings account. If you do borrow from your savings account, try to keep at least one month’s living expenses on hand (or $1,000), whichever is higher.
Alternative 2: Consider a home equity loan
You could also consider a home equity loan, or second mortgage, which allows you to borrow a lump sum using your home’s equity.
You can get a home equity loan through banks, credit unions or online lenders and choose from a variety of repayment periods, many longer than the five-year range for 401(k) loans. However, that repayment period depends on your credit score, home equity availability and financial situation.
You’ll get a sense of what you can borrow, your interest rate, monthly payment, the term of the loan and any fees involved. Once you agree to the loan terms, you get a lump sum and can pay back the loan over time in fixed monthly payments.
Think Carefully About Your Retirement Money
What became of my relative? Sadly, he passed away about 10 years later with nothing to pass on to his wife, kids or grandkids, and I always think of that well-intentioned 401(k) plan that he had. It always makes me sad to think about it, and I don’t want that to happen to others.
When you need money during these difficult financial times, you maybe tempted to borrow from your 401(k). However, remember that your ticket to a successful future sometimes lies in those retirement funds. Take this decision very seriously!
If you have to borrow money, look into several alternative options to compare fees and interest rates on a home equity loan or another type of loan. Compare those rates to how much you’ll pay borrowing from your 401(k).
Melissa Brock is a 12-year veteran of college admission, founder of College Money Tips and Money editor at Benzinga. She loves helping families navigate their finances and the college search process. Check out her essential timeline and checklist for the college search!