Three Must-Dos If Taking a 401(k) LoanAugust 1, 2018 Judith Ward, CFP®, Senior Financial Planner
- Borrowing from your employer plan affords you the flexibility to access a large amount of your own money that you pay back to yourself with interest.
- Understanding the benefits and drawbacks can help you make a better informed decision. Continuing to contribute to your plan while paying back the loan is the best action you can take to keep your retirement savings on track.
- If you use 401(k) loans perpetually or for everyday expenses, see if your employer offers financial wellness programs that can help you manage your daily finances while planning for a secure retirement.
Like a lot of financial institutions, T. Rowe Price conducts surveys to better understand investor behavior. One recent survey1 found that close to a quarter of parents had taken money out of their retirement savings within the past two years to pay for kids’ education, wedding expenses, vacations, and holiday spending.
As a financial planner, these don’t seem like the right reasons to take money from a retirement account. Further, I suggest it’s best to save for these activities separately instead of raiding your retirement savings.
Overall, our survey found that paying off debt was the most frequently cited reason that folks used savings earmarked for retirement. While taking money out of retirement accounts isn’t always ideal, a workplace retirement plan may be an option for borrowing money if no other reasonable alternative exists.
If, after careful thought, you’ve decided to take a loan from your 401(k), here’s how to keep your retirement savings on track:
1. Make borrowing from your 401(k) a one-time option.
Never take a loan from your 401(k) plan just because you can; it is not your personal ATM. If you are in a situation where you have to take on debt, a 401(k) loan offers these advantages:
- While your plan may charge a small loan-processing fee, no credit check is required and the loan will not impact your credit history.
- You pay the money, including the interest, directly back to your account. Additionally, the interest rate is typically much more favorable when compared with a high-interest credit card or a payday loan.
- It’s a relatively quick and easy process.
2. Proceed with caution.
There are drawbacks to keep in mind when taking money out of your retirement plan:
- If you leave your job (your choice or not) and have an outstanding loan, make sure you understand your obligations. Many plans require that the loan be paid back in full upon termination of employment. If you can’t pay it back, it will be treated as a distribution and will be subject to taxes and a possible early withdrawal penalty.
- Typically, your loan repayment is automatically deducted from your paycheck; however, if you miss a payment, the loan could be considered in default and will be treated as a distribution.
- You lose potential compounded growth of the money you have taken out of your 401(k). The interest you’re paying back is usually much less than what your funds could earn in the market. This loss could be more pronounced the further you are from retirement.
3. Keep contributing to your 401(k).
The best action you can take is to keep up your contributions while paying back the loan. At T. Rowe Price, we find within our own retirement plan business that 89% of people who have an outstanding loan against their plan continue to contribute. Most 401(k) plans allow you to continue your contributions. If your plan does not, you may want to think hard about this decision.
If you find yourself in a situation where you are a serial loan taker or are using these funds for everyday expenses, see if your employer offers financial wellness programs that can help with budgeting and debt reduction. These programs, which emphasize saving for emergencies and other financial goals, can help you manage your daily finances while planning for a secure retirement.
The financial planner in me is hesitant to suggest taking a loan from one’s retirement savings. However, as someone who is saving for my own retirement, I realize that life happens, and sometimes we need to do things to help us through those rough patches. Keeping these three considerations in mind can help keep the impact of a loan manageable without derailing your retirement savings.
12018 T. Rowe Price Parents, Kids and Money Survey.
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