It's sometimes necessary for workers to borrow money from their 401(k) plan to pay for an emergency expense. Retirement savers are generally permitted to borrow as much as 50 percent of their vested 401(k) balance up to $50,000. However, it's best if you use a 401(k) loan only as a last resort. Here's why you should be cautious about taking a 401(k) loan:
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You may not be able to borrow much. Most, but not all, 401(k) plans permit loans. When they are allowed, you can borrow $50,000 from your 401(k) plan if you have a vested account balance of $100,000 or more. If you have less than that, you can only borrow up to half of your account balance. For example, if your account balance is $40,000, the maximum amount you can borrow from the account is $20,000. The amount you are eligible to borrow is further reduced if you had an outstanding loan from a 401(k) plan in the previous 12 months.
Most people borrow a small amount from their 401(k) plan. Fidelity says 10.6 percent of their 12.3 million retirement plan participants took out a new loan in the past year, borrowing an average of $9,000, and 22 percent have outstanding loans. The 18 percent of Vanguard 401(k) participants who had an outstanding loan in 2012 also owed an average of $9,000.
Quick repayment is required. A 401(k) loan generally must be repaid within 5 years, and payments must be made at least quarterly overly the life of the loan. A loan used to buy the account owner's main home may be paid back over a period of more than 5 years, and loan repayments may be suspended for employees performing military service. A worker can take a leave of absence from loan repayments for up to one year, but must make up the missed payments by increasing the monthly installments or paying a lump sum at the end so that the loan is repaid within the original 5-year term.
A loan could become a distribution. Taxes are not due on 401(k) loans unless you don't repay them. However, if you fail to make all the payments, the entire outstanding balance of the loan will be considered a 401(k) withdrawal and income tax will become due on the distribution. If you are under age 59 1/2, a 10 percent early withdrawal penalty may additionally be applied to the withdrawal. Also, if you leave your job or are laid off before paying off the loan, the balance of the loan often becomes due. Fidelity found that 10 percent of 401(k) participants who initiate a loan go on to take a hardship withdrawal, and incur the resulting taxes and penalties.
Fees. Retirement savers who take out 401(k) loans often encounter a variety of loan costs in addition to interest, including origination, administration and maintenance fees. "Loans are expensive to administer and loan origination and maintenance fees are increasing," according to a recent Vanguard analysis of 2,000 401(k) plans with 3 million participants. "With loan fees, sponsors can allocate costs directly to those participants incurring loan-related expenses."
Missing out on market returns. The cash you borrow from your 401(k) is generally paid back at a fixed interest rate. It does not earn the market rate that would have been accumulated if the money had been left in the account, which could be higher or lower depending on how the market performs and the investments selected.
Less retirement preparedness. 401(k) loans are generally less damaging to your retirement savings than a cash out or hardship withdrawal, because in many cases 401(k) participants pay the money back with interest. You may even be able to have the loan repayments withheld from your paycheck to help insure that you won't miss any. But 401(k) loans are still likely to ultimately hurt your retirement nest egg. "When you take the loan you need to consider whether or not you are going to be able to afford the loan repayment and continue to contribute," says Jeanne Thompson, Fidelity's vice president of thought leadership. Fidelity found that borrowers contribute an average of 2 percent less to their 401(k) plans while paying off the loan and for two years beyond the loan repayment date. "They are not saving as much as they were," Thompson says. "So when they get to retirement they have less."
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