Some retirement plans offer a loan feature, allowing participants to borrow from their account balances and pay the loan back via payroll deduction.
We get a lot of feedback from plan participants that “I’m paying myself back so this is a good idea” or “I don’t have any other options so I need to take this loan from my plan.” Taking a loan from your 401k may seem logical for those reasons, but there are other factors to consider.
- Interest rates are on the rise but are still very low. Most plans charge the prime rate + 1% for loan interest. That number most likely is not as high as what those funds were earning when they were invested in the plan, therefore you are giving up potential earnings by “paying yourself back.”
- Opportunity Cost: the amount you would have earned on the funds had they stayed invested over the long term; that could be 8-10% on average with stock funds or 6-8% with a more moderate mix.
- Many people stop their salary deferral contributions when they take out a loan as they realize the payment and deferral cut into a large amount of their take home pay; by doing this you could be leaving money on the table if your company matches what you are contributing.
- If you leave the company, most likely you must pay the loan back in full within 60 days or take the remaining balance as a distribution and pay taxes (and possibly a penalty if you are under 59 ½) on it.
- Your retirement account is protected from creditors. If you take a loan from your 401k to pay off debt and then run into more financial difficulty and need to file bankruptcy, you will still have to pay back the 401k loan – it will not be eliminated. Had you left the money in your retirement plan and looked for other ways to get your financial life in order, you would still have the balance in your 401k plan.
In summary, while 401k loans may be available as an option in your plan, they are not always the best way for you to obtain the loan money you might be needing.