For many people, their largest financial asset is their retirement savings in a 401k account. I know it must be extremely tempting to borrow money from your 401K plan in certain situations and not everyone can resist these temptations.
Statistics say that since the year 2000 about 20% of all 401K participants had a loan against their 401K outstanding. Personally I feel that is very scary because not only does it stop people from saving money for retirement for a short period of time, but actually for a prolonged time because the 401K loan needs to be repaid and I think it is safe to assume that additions to the 401K balance are not happening either.
Why is a 401K loan such an attractive option compared to taking out a loan from a bank?
Technically, 401(k) loans are not really true loans. These types of loans do not involve either a conventional lender or get registered in your credit history. On top of that, your actual credit score does not matter and a bad credit score will not affect the interest rate of your 401K loan accordingly. But there are some restrictions in case you want to borrow money from your 401 K account.
What are the rules about borrowing money from your 401K?
The maximum amount that you may take out as a loan from your 401k plan is limited to 50% of your vested account balance. “Vested” is critical to mention here as quite a few employers put a lock on their contributions to an employee’s retirement savings plan and the employee cannot borrow against the unvested employers portion..
A second limitation is the maximum about one can borrow in actual dollars. This is limit is set to a maximum amount of $50,000.
So, what does that mean in real life?
As an example, if you currently have $50,000 in your vested account balance you would be able to borrow up to $25,000 from your account – if all of that money is all yours and you are fully vested on the employers portion. To be able to borrow the full $50,000 you would need to have at least $100,000 in your account (still assuming that you are fully vested).
If 50% of your vested account balance is equal or less than $10,000, you may borrow up to $10,000.
Interest payments & Interest Rates
Like a conventional loan, loans taken out of your 401 K balance require interest payments. The plan provider in combination with your employer determine what interest rate applies to a 401 K loan an employee takes out.
However, here is some good news for you if you consider taking out a loan from your retirement savings plan. The interest that you are required to pay for taking out the loan actually goes back into your own account at the 401K plan provider. While it may sound confusing, overall it is a good thing for you. You be paying the interest to yourself and this offers the opportunity to make up for lost performance within your investments. But don’t get too excited, the interest you will be paying yourself is really just a drop in the bucket and in no way makes up for the loss of investing performance. Interest rates that apply for 401 K retirement savings plans are usually much lower than conventional loans you can take out from a bank.
There are fees …
Just because interest rates for 401K loans are a bit lower than conventional loans from a bank, do not think this is free money. Every time you take out money from your retirement savings plan administrative fees apply and in the end eat into the consolidated performance of your 401K savings.
How prevent the need for a 401K loan?
If you are currently in a stable financial position you have some options to avoid the need to borrow money from your 401 K plan. The best way to resist using a retirement account to fund a loan is to build emergency savings as quickly as possible. Of course it depends on your overall situation, but the faster you can put money into a high-yield savings account and use it as your emergency fund, the better of you will be. Don’t wait until disaster strikes, but start saving money today. Even small amounts add up quickly and might make that necessary difference for you. Don’t feel intimidated by what the financial experts recommend as what one should have in an emergency fund. Everyone started with a small balance at one point. As long as you become a disciplined saver and keep adding to that account all will be good. Having an emergency fund is like getting insurance for your future self.
Borrowing money from your 401K plan is like committing robbery from your future retirement. Taking out a loan will slow down investment performance. It will negatively affect the compounding effect of your investments. It creates a significant investment gap from the day you sell investments to release the cash until you have a) repaid the entire amount (+interest) and pick up your regular 401K contributions again. To be able to make up for the loss of investment performance you should really double your future contributions.
Be smart when you borrow money from your 401 K plan – do not reduce or stop your current contributions. See if you can continue putting money into your 401 K as much as possible. Not only would you be reducing the negative impact of the loan, but you can also continue to collect the employer match to your 401 K savings.
Life throws curveballs all the time. According to a new Deloitte study nearly 10 percent of all 401K loans default each year – inflicting dramatic damage to one’s ability to retire. Just reading this makes me cringe already. Not only is the loan amount at stake, but now a 10% penalty and additional income tax applies for this “early withdrawal”.
Let us know in the comments if you ever took out a loan from your 401K Retirement Savings Plan and how you feel about it now after reading this “Retirelicious” blog post.