According to the Investment Company Institute, there’s nearly $4.5 trillion in 401k retirement accounts representing about 18% of all retirement assets. But many people for various reasons have taken out a 401k loan.
Even though they’re popular, 401k loans can be confusing. Making a bad decision on a 401k loan could put your retirement savings in jeopardy. So we contacted Certified Financial Planner® Jeff Nordin to help us understand 401k loans. Jeff has an MBA from Cornell University, founded CoreFinancialConcept.com and has over 20 years of experience advising clients.
Q: Why are people so quick to take out a 401k loan?
Mr. Nordin: 401k loans seem to be driven by people looking to pay off credit card debt or experiencing an emergency.
People should look to borrow from their 401k only if no other options remain. The two biggest reasons for this are removing pre-tax dollars from your 401k but repaying with after-tax dollars and reducing the earnings power (tax-free) of your retirement money.
That said if your plan allows for loans, you may borrow up to 50% of your vested account balance, or $50,000, whichever is less. Also, employers can put stipulations on what the loan can be used for, and loans must be paid back within five years.
Q: What are some of the reasons that you’d want to repay a 401k loan as quickly as possible?
Mr. Nordin: The single biggest reason is to get those funds back in your 401k growing free of taxes. The power of this over time is a huge ally toward having a sufficient retirement fund down the road.
Q: Some are advocating using a personal loan to pay off a 401k loan, especially since there are so many new lenders like SoFi, Prosper, Lending Club, etc. available. What advantages could there be for the borrower?
Mr. Nordin: The big advantage is paying your 401k back sooner rather than later.
Low rates could be another advantage. Even though you are "paying yourself" the interest (401k loans are typically one or two percent above the prime rate, currently 3.5%), you’re not just paying interest, but also missing out on earning a tax-free return on the borrowed funds. If one expects an 8% return, that 401k loan could be "costing" you 13% or more!
Q:There are always some drawbacks. What’s the downside of using a personal loan to repay a 401k loan?
Mr. Nordin: One real potential disadvantage would be paying a substantially higher interest rate on a personal loan.
Q: Are there any circumstances where the personal loan or 401k loan is always better?
Mr. Nordin: Rate and terms comparable, a personal loan would almost always be superior to borrowing from your 401k.
Q: Are there any questions that the borrower should ask themselves before making a final decision?
Mr. Nordin: The easy-for-me-to-say-to-ask-yourself questions are "Why is it that I need to borrow in the first place?" and "What steps do I need to take to get my financial life in better order?"
Exhaust all options, including personal loans and even borrowing from family, before resorting to a 401k loan.