401(k) loans or loan sharks?
BORROWING AGAINST YOUR FUTURE
DOES IT MAKE SENSE TO TAP YOUR RETIREMENT SAVINGS?
The whole idea behind retirement savings is to keep accounts accumulation so that, when you leave the working world behind, you’ll have enough assets to write your own paychecks. But what if you’re in need of some serious cash to bail out of an emergency, cover a major expense, such as college tuition or a down payment for a home, or fund a business venture? Is it wise to tap your retirement savings?
If you participate in your employer’s 401(k), you may be able to borrow up to 50 percent of your vested account balance, up to a maximum of $50,000. Most employers will give you up to five years to repay the loan at a “reasonable” rate of interest-typically one or two percent above the prime rate. These days that’s about six-to-eight percent.
If you only need a short-term loan, an IRA could offer the solution you’re looking for. You can tap an IRA’s balance and avoid both penalty and taxes by rolling the borrowed funds back into an IRA within 60 days. The same strategy applies to a 401(k), but your employer will withhold 20 percent against taxes, even if you intend to repay the loan. To recover the 20 percent, you’ll have to apply for a tax refund after you put the money back in your account.
For certain personal, medical, home-buying, or higher education expenses, special hardship withdrawal provisions allow you to draw from your 401(k) or IRA accounts. Such withdrawals are subject to taxes, but the penalty is waived if you stay within the guidelines, which vary between 401(k)s and IRAs. For example, to pay child support you can take a penalty-free withdrawal from a 401(k), but not from an IRA.
When is a loan or a withdrawal from your retirement savings the best way to meet your financial needs? In a real emergency, it’s almost certainly better to borrow from your 401(k) than to take a cash advance from your credit card, with its double-digit interest rate, or to borrow from a bank. Taking a hardship withdrawal from your 401(k) or IRA to make a down payment on a home can be a smart move because it should enhance your overall tax situation. You’ll be able to deduct the interest on your mortgage payments, build up equity, and say goodbye to rent payments that go nowhere.
Before dipping into your retirement savings, however, it is vital to consider all of the consequences. If you borrow from your 401(k) but don’t repay the loan, for example, you are certain to end up with less in your retirement account at the end of the road. Even if you repay the money at a higher rate of return than the account would have earned you’ll lose out on years of tax-deferred compounding. Since the loan is repaid with after-tax dollars, your actual borrowing costs are higher than they seem. This is where you need to question if this a prudent loan to take on, and even “is this loan-sharking”. After borrowing $15,000 from your plan you are given a payment schedule of $300 per month for the next five years. The actual costs are higher than they seem. $300 multiplied by 60 is $18,000. Let’s look a little deeper into the real economics of the 401(k) loan. If you are in the 32% tax bracket (27% fed and 5% state) you actually have to earn $441, pay income tax of $141 to get the $300 for the monthly payment. The total cost of this venture is $26,460 ($441 X 60). When you do retire and take distributions from your plan, the money you paid the loan back with is taxed twice. Once when you repaid the loan and again when you withdraw the money as income. Double taxation? Loan-sharking? You decide.
If you have a solid plan to start your own business, but lack the capital to get it off the ground, a loan against your 401(k), or a withdrawal – even when a penalty is involved – could make significant difference to your future. This strategy works best when you are young because it gives you time to catch up on retirement savings once your business is off the ground. If you’re over 50, the risk clearly is greater because time is no longer on your side.
There are additional risks to borrowing from your 401(k). If you leave your job, or if your company is merged and your plan terminated, you’ll be required to repay your loan within two to six months (depending on your plan’s policies). If you can’t come up with the money, the loan will be taxed and penalized as an early withdrawal. If that’s not bad enough, consider this: the borrowed money is permanently lost to your tax-deferred account. You can’t ever repay it.
So, be honest with yourself about your prospects for repaying your loan or beefing up future retirement savings to offset the withdrawal that you make today. Because the rules that govern loans and withdrawals are complex, it makes sense to get professional tax or financial advice before deciding on a strategy. An investment professional can be an excellent resource to help you sort out the rules, weigh your options, and guide you through the paperwork. Remember, if it’s a real emergency and you decide it’s worth tapping your retirement savings, in addition to borrowing the funds you need, you don’t want to also borrow trouble from the IRS.