When should I take a loan from my 401k?
You should ask yourself a few questions before first taking a 401k loan or 401k withdrawal from your hard earned retirement savings plan. First of all, I am going to talk about 401k loans. If you do not work for the company that handles your 401k you are not able to take a loan. If you are active, however, you may still not be able to take a loan from your 401k plan. This depends on many factors and they are all spelled out in the plan rules. But, many plans do offer 401k loans and this first section will be about the plans that do offer this option.
Before you go ahead and commit to a loan from your retirement plan you need to first consider a few things:
1.) Can I really pay back all of the money that I am borrowing in a timely manner?
- If you cannot pay back the money then don’t borrow it. It’s as simple as that. If you cannot pay back money into your 401k retirement strategy then you have no business taking money out whether it’s to fund a car purchase, house, boat, mortgage payment, etc. There is no more vital figure of retirement and long term savings than your 401k plan.
2.) Do I really need to borrow the maximum amount available to me?
- The way that 401k loans work is that you can borrow up to 50% of your vested balance as long as that balance does not exceed $50,000. This is the case for most 401k plans that offer loans. However, just because you can take a 401k loan doesn’t mean that you should. Tapping into your 401k should only be done in a last resort type of situation.
3.) Is the stock market going up or going down?
- It is hard to time the market, however it also doesn’t take a genius to know when the stock market is at a bear and when it is at a bull. If the market is going down considerably, you may be tempted to take your money out of your 401k and invest in something differently. However, you probably aren’t able to make any withdrawals, so you try to take a 401k loan. This is the worst possible move. What happens when you take a 401k loan is your remove the loan balance from your plan meaning the balance does not get invested while you are paying it back. So, if the market is at a low and you take money out and it double in two years and you make a loan for three years, well then you have just missed out on a huge amount of money. Take this scenario:
You take a 401k loan out of your plan when the market is at 10,000. Your 401k balance is at $40,000 and is all invested in a diversified mix of stock mutual funds. You are able to take a $20,000 and can pay the loan back in 5 years. Over the past 3 years the market has dropped from 15,000 to 10,000. You take your loan at 10,000 to pay off an auto loan at 7.5%. The next three years the market doubles, going to 20,000, an all-time high. The $20,000 you have had invested goes to $40,000 over the three year period, a gain of 100%, however the loan that you took out does not get invested and gains nothing. You have paid back three years of the five year loan. Here are how the figures work out:
Taking the loan, balance after three years with market doubling:
$52,000
Not taking the loan, balance after three years with market doubling:
$80,000
That is a $32,000 difference. Does that make you rethink paying off that low interest car note?
I know what you are thinking ” The market and the economy is so unstable nowadays, it makes more sense to pay off things that are tangible like my house or my car.” However, this thought process is farthest from the truth. By taking a 401k loan you are essentially taking away three to five years worth of interest on your money to pay down something that won’t benefit you ten years from now.
4.) Where are interest rates now?
- One of the main benefits of taking a 401k loan from your retirement plan is that the interest rates on the loans are currently very small. The rates will change according to interest rates, but the interest is paid back to you, so all of the money will eventually come back to you, the main caveat being that your money isn’t invested while it’s being paid back. Some people will say that the double taxation of 401k loan interest is a big deal, however in many cases it isn’t and especially if you are paying 3.25% fixed on a five year 401k loan. There simply isn’t enough interest generated for it to make a big impact.
5.) Can you pay back the loan within a year?
- 401k loans will make you abide to their rules. You have to pay back a portion of the loan with each paycheck and the terms of the loan that are set up initially can never be changed. However, you can pay back the loan early at any time but you must pay back the loan in full. You cannot, for example, make double payments of the loan to pay it off a year early, you must pay the full loan balance off at once or continue with the scheduled payments. So, most people just make the payments because they didn’t have they money to pay the loan off in the first place or else they wouldn’t have taken the loan. But, if you do find a windfall, make sure you pay off your 401k loan as quickly as possible to keep that extra money working for you.
6.) What If I don’t pay the loan back?
- Sometimes you may not have a choice. If you still work for the company, most companies will not let you involuntarily reclassify a 401k loan. This means that you can’t just say that you won’t pay the loan back. If you sign up for the loan it must be paid back with every paycheck or until you stop working for that company, you cannot contact your HR area and have them block the 401k loan repayments. The IRS sets heavy restrictions on this for a reason to keep people from getting their hands on their retirement assets and messing up their long term lifestyles.
- If you do end up leaving the company plans have different options. Some plans will let you continue to make payments as usual on your 401 loan via an ACH bank transfer on the same basis as your paycheck and other plans will make you either pay the full loan amount off within a set amount of time (usually 90 days) or the loan will automatically get reclassified as a withdrawal from your 401k plan. When your loans get reclassified as a withdrawal you will be subject to taxes and penalties on the balance as if that amount were withdrawn from your 401k that same day. I will go into more detail on 401k withdrawals on the next post.