Pros And Cons Of Borrowing Against 401k - The financial media has coined many pejorative terms to describe the problems of borrowing money from 401(k) plans. Some, including financial planning professionals, even believe that borrowing from a 401(k) plan is a committed robbery against your retirement.
However, in some cases, a 401(k) may be loanable. Let's see how such a loan can be used wisely and why it won't pose a problem for your retirement savings.
Pros And Cons Of Borrowing Against 401k
Looking for cash for a serious short-term liquidity need, a loan from your 401(k) plan is probably one of the first places you should look. Let's define short term as about a year or less. Let's define "critical liquidity need" as a one-time critical demand for funds or a one-time cash payment.
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Put it this way: "Let's face it, in the real world, sometimes people need money. Borrowing from a 401(k) can be smarter than taking out a high-interest loan, a pawnshop, or a payday loan, or even a more affordable personal loan. Will spend less time. It will be done."
Why is a 401(k) an attractive source of short-term loans? Because it can be the fastest, easiest, cheapest way to get the cash you need. Borrowing from a 401(k) is not a taxable event unless the loan limits and repayment rules are violated and it has no effect on your credit rating.
Assuming you pay off the short-term loan on schedule, it will generally have little impact on your retirement savings progress. In fact, in some cases, it can even have a positive effect. Let's dig a little deeper to explain why.
Technically, 401(k) loans aren't real loans because they don't involve an evaluation of the lender or your credit history. They are described as an opportunity to take a portion of your retirement plan money (usually up to $50,000 or 50% of assets, whichever is less) tax-free. Then you must return your 401(k) plan under rules designed to return it to approximately its original condition before the transaction.
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Another concept that causes confusion in these transactions is the term interest. Any interest accrued on the outstanding loan balance is paid by the participant into the participant's own 401(k) account, so technically it is also an out-of-pocket transfer, not a loan expense or loss. Thus, the value of a 401(k) loan relative to your retirement savings progress may be minimal, neutral, or even positive. But in most cases, it will be less than the cost of paying the actual interest on a bank or consumer loan.
Applying for a loan with most 401(k) plans is quick and easy, with no lengthy applications or credit checks required. Generally, this will not affect your credit inquiry or your credit score.
Most 401(k) loan requests can be made with a few clicks on the website, and you can have funds in hand within days in complete privacy. An innovation now being adopted by some schemes is the debit card which allows multiple loans to be made in smaller amounts.
Although the rules specify a five-year amortization repayment schedule, for most 401(k) loans, you can pay off the plan loan early without a prepayment penalty. Most plans allow you to pay off debt easily through payroll deductions, using after-tax dollars instead of pre-tax dollars that fund your plan. Your schedule reports show the amount owed on your credit account and your remaining principal, just like a regular bank credit report.
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Finding your own 401(k) money for short-term liquidity needs costs nothing (except perhaps a modest loan origination or administration fee). Here's how it usually works:
Specify the investment account(s) you wish to borrow from, and those investments expire over the term of the loan. Then you lose any positive returns that those investments might have had in the short term. If the market is down, you sell these investments for less than at other times. The advantage is that you can avoid additional investment losses on this money.
The cost benefit of a 401(k) loan is equal to the interest rate charged on a comparable consumer loan, minus the investment income lost on the principal you took out. Here is a simple formula:
Cost benefit = cost of consumer credit interest - lost investment income \ start text = &text - \ &text \ \ end cost benefit = cost of consumer credit interest - lost investment income
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Let's say you can take a personal loan from a bank or get a cash advance from a credit card at 8% interest. Your 401(k) portfolio earns 5%. Your cost benefit for borrowing from a 401(k) plan would be 3% (8 - 5 = 3).
When you can predict that the cost benefit will be positive, a loan plan can be attractive. Note that this calculation does not take into account any tax implications, which can increase the benefits of plan loans because interest on consumer loans is paid in after-tax dollars.
When you make loan payments to your 401(k) account, they are typically put back into your portfolio's investments. You'll pay a little more than you took into account, and the difference is called "interest." If any lost investment income qualifies for a paid 'phase', the loan will have no (ie neutral) effect on your pension, meaning the earning opportunity is offset dollar for dollar by interest payments.
Taking out a 401(k) loan can actually boost your retirement savings progress if the interest paid outweighs any lost investment income. However, remember that this will reduce your personal (non-retirement) savings proportionately.
Why You Should Never Borrow From Your 401(k) Plan
The above discussion leads us to another (false) argument about 401(k) debt: By withdrawing the funds, you will dramatically disrupt the performance of your portfolio and the building of your retirement nest egg. This is not necessarily true. First of all, as mentioned above, you repay the amount and start doing so soon. Given the long-term horizons of most 401(k)s, that's a fairly small (and financially insignificant) gap.
Percentage of 401(k) participants with unpaid plan loans in 2016 (new data), according to a study by the Employee Benefit Research Institute.
Another problem with justifying negative impact investing: it tends to assume the same rate of return over the years, and – as recent events have made surprisingly clear – this is not how the stock market works. A growth-oriented portfolio focused on stocks will fluctuate, especially in the short term.
If your 401(k) is invested in stocks, the actual impact of payday loans on your retirement progress will depend on the current market environment. In strong bullish markets, the effect should generally be negative, and in sideways or bearish markets, it can be neutral or even positive.
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Scary but good news: The best time to take out a loan is when you feel the stock market is weak or weak, such as during a recession. Incidentally, many people need money or want to stay liquid during such times.
There are two other common arguments against 401(k) loans: The loans aren't tax-efficient and create a big headache when participants can't pay them off before they leave or retire. Let's counter these myths with facts:
The claim is that 401(k) loans are tax-deductible because they must be repaid with after-tax dollars, and loan repayments are subject to double taxation. Only the interest portion of the payment is subject to such treatment. What the media usually fails to note is that the cost of double taxation on loan interest is often very low compared to alternative ways of obtaining short-term liquidity.
Here's a hypothetical situation that's often very real: Let's say Jane increases steady retirement savings by deferring 7% of her paycheck into her 401(k). However, he must soon come up with $10,000 to pay for his college tuition. He says that this amount can be recovered from his salary in about a year. It is in the combined federal and state tax bracket of 20%. It has three ways to earn cash:
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Double taxation of 401(k) loan interest becomes a meaningful expense only when large amounts are borrowed and then repaid over multi-year periods. Even so, it often costs less than alternative means of accessing the same amount of cash, such as a bank/consumer loan or a break in plan deferral.
Let's say you take out an unplanned loan and then you lose your job. The loan must be paid in full. If you don't, the full unpaid loan balance will be considered a taxable distribution, and if you're under age 59½, you may face a 10% federal tax penalty on the unpaid balance. Although this scenario is an accurate representation of tax law, it does not always reflect reality.
When they retire or leave a job, many people choose to take a portion of their 401(k) money as a taxable distribution, especially if cash is tight. An outstanding loan balance has similar tax consequences to this option. Most plans do not require plan distributions upon retirement or separation
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