By Alessandra Malito
July 8, 2021
As the pandemic has shown, Americans’ retirement savings can come in handy when in the midst of an emergency, such as a job loss or medical event—but some people may want to use these nest eggs for other financial purposes. That can be OK in some situations, financial advisors said.
Typically with a 401(k) loan, a worker can take the lesser of $50,000 or 50% of the vested account balance on a tax-free basis, said Danielle Harrison, a certified financial planner at Harrison Financial Planning. The funds must also be repaid within five years, unless it was used for the purchase of a primary residence, in which case they are allowed a longer duration.
People may turn to a 401(k) for a loan instead of borrowing from a bank or financial institution, asking families and friends or wracking up a substantial amount of debt on a credit card. Congress temporarily expanded the rules for taking a loan from a retirement plan during the height of the pandemic as a way to address lost jobs, reduced wages or other costs and expenses related to Covid-19. “Emergencies occur that can warrant the use of a 401(k) loan,” Harrison said.
A few things to be aware of when taking a loan from a 401(k) for a non-emergency:
When taking a 401(k) loan, the worker needs to create a repayment plan and those repayments are made with after-tax dollars. Most importantly, the loan must be repaid immediately if the borrower leaves their job, which could come as quite the surprise to someone if they are unexpectedly let go or need to leave their jobs while a loan is in place. If the loan is not repaid, it will be treated as a withdrawal and subject to income tax and possibly a 10% penalty if the employee is under 59 ½ years old.
The loan could also cost workers money in the future, such as employer matching contributions and any earnings on the invested assets, said Rob Greenman, a certified financial planner and partner at Vista Capital Partners. When money is lent from a 401(k), the balance decreases, which reduces potential returns.
Some plans do not allow workers to continue contributions while repaying their loan, Harrison said. “This can derail your retirement savings plan and eliminates your ability to take advantage of any available employer match,” Harrison said.
Instead of using a 401(k) loan, whenever possible, individuals should earmark a portion of their savings to whatever goals and non-emergencies they want to pay for, said Linda Farinola, a certified financial planner and partner at Princeton Financial Group. “A 401(k) account is for retirement,” she said. “Loans are there for emergencies but vacation and home improvements are not emergencies.”
Workers considering a 401(k) loan should ask themselves a few questions first, such as how much of an impact that distribution, if only in the form of a loan, could have on their retirement account balances and if their retirement can afford to have this much less money when it’s time , said Sean Pearson, a certified financial planner and associate vice president with Ameriprise Financial Services. “For many people who are not already ahead of pace in their retirement savings, the answer to that question might be no.”
Take for example one 50-year-old who takes a $50,000 loan over five years and one 50-year-old individual who doesn’t. The person who took the loan could lose out on thousands of dollars in investment returns during that five-year span compared to her counterpart who did not take the loan, and would need to pay more into her account every month to catch up by retirement. If not, the difference in their retirement portfolio balances could be substantial — perhaps nearly equivalent to the amount of the initial loan.
“Most financial decisions look different if you plot them along a timeline,” Pearson said. “For a 401(k) loan, it’s important to look at both the term of the loan and what that means for your future savings.”
Still, some people may be more comfortable with a certain level of debt and the risks associated with taking this type of loan, in which case drawing from a 401(k) could make sense. “Some individuals absolutely hate the idea of debt no matter the amount or type,” said Zachary Bachner, a certified financial planner at Summit Financial Consulting. “Some are more aggressive in nature and are more willing to leverage their finances.”
A 401(k) loan could be a better debt instrument than some other types of loans or credit cards, Bachner said. “You essentially pay yourself the interest on the loan, so 401(k) loans are usually mathematically the better options versus other consumer loans. Even the interest rate alone is normally much lower than personal loans available at the bank.”
This loan would be even more attractive if the worker has excess savings every month and can pay the loan back quickly. The end goal: if the loan is being taken, be sure to be financially comfortable and in a stable work environment, and aim to repay the loan as soon as possible.
“The larger the loan or the longer the duration of the loan, the less attractive the debt becomes,” Bachner said.