About 20 percent of all company employees steal from themselves — and, shockingly, most feel good about it. This act of self-robbery, also known as borrowing against your 401(k), is all very legal, and readily condoned by corporations and the government. In fact, many hard-working employees regularly do it to pay off debt (46 percent), pay off emergency expenditures (35 percent), fund a home purchase or renovation (26 percent), pay bills due to job loss (24 percent), cover education costs (20 percent) and pay for weddings, vacations or other special events (15 percent), according to TIAA-CREF’s (Teachers Insurance and Annuity Association – College Retirement Equities Fund) 2014 Borrowing Against Your Future Survey.
Why it’s not as taboo as you think
Indeed, there are definitely taboos associated with raiding your retirement accounts to help pay for some of life’s necessities (opportunities), as commonly advised by personal finance experts. However, what you rarely hear is how advantageous it can be for you to use money from your 401(k), should you need it.
Some of these advantages of borrowing against yourself include not having to undergo any credit checks or inquiries that could show up on a credit report or ding your FICO score. The transaction takes places in privacy between you and your company and outside the purview of the credit agencies.
Are there tax penalties?
As for tax penalties, there are none, as long as you pay yourself back in the prescribed time. You’re not withdrawing money; you’re temporarily borrowing it, as if the transaction never happened.
When you start repaying the borrowed money (the lesser of 50 percent of your account or $50,000) to make your retirement account whole again, the interest (usually 1 percent over the prime rate) you pay on your “self-loan” goes to you. As such, the cost of a 401(k) loan on your retirement savings progress can be minimal, neutral, or even positive, but in most cases, it will be less than the cost of paying real interest on a bank or consumer loan.
Clearly, 401(k) loans have a following, so let’s outline a few scenarios of how these loans can be used sensibly, before sharing a few caveats that you should give you pause whenever you’re meddling with something as vital as your retirement savings.
To pay off debt
This is the number one use for tapping your 401(k). Typically, your 401(k) loan tacks on 1 percent interest to the prime rate, which as of Oct. 7, was 3.25 percent.
So, figure on paying yourself back at 4.25 percent, which is vastly superior to the interest rates (on average from 13 percent to 22 percent) that banks charge their credit-card happy customers.
To cover an emergency expenditure
Life is filled with emergencies. Sometimes, if you play hard, you can fall hard, tearing your meniscus or ACL sliding into home plate at the company softball game or breaking a few ribs in a pick-up basketball game. Even if you have medical insurance, you’re carrier likely won’t pick up the entire tab.
If you had an open home equity line of credit, you might be tempted to tap those funds first. Rates listed on MyBankTracker’s HELOC page, as of Oct. 7, showed interest rates ranging from 4 percent at Alliant Credit Union to 6.9 percent at Bank of America. So, those rates compare favorably or they’re at least in the ballpark with your 401(k)’s 4.25 percent. And a HELOC may be tax advantaged (tax deductible on up to $100,000 for expenses that don’t deal with your home).
But if you don’t have one, there’s all that initial paperwork to fill out. Plus, HELOCs adjust monthly, usually with no limit on the size of the adjustment. Should you fail to pay back your loan, you could lose your home.
To help fund a down payment or home renovation
When it was time to remodel my kitchen 10 years ago, I didn’t like the idea of taking on a home equity loan (a second mortgage) to pay for it. I had been paying into my employer’s matching 401(k) for several years, so the idea of self-financing the renovation appealed to me very much, especially at a rate 1 percent above prime, which made my rate 5.75 percent at the time. Again, I would be paying this borrowed money back to myself. If I had taken out a home equity loan, I would have incurred upfront fees plus a home equity loan interest rate, then at about 9 percent (about three percentage points higher than what 30-year fixed rate mortgages were going for).
I was given five years to repay the $10,000 loan (to myself), so I never felt the payments would be a hardship I couldn’t handle, as they were automatically and painlessly extracted from my paycheck.
At the same time, I understood that if I were laid off by my company, I would have 60 days to pay off the loan total; otherwise, I would incur a 10 percent tax penalty and regular income tax on my withdrawal. I also realized that by my removing a chunk of my 401(k) savings, repaying about $2,000 a year, my retirement account would be losing a little steam, but at the time I was still in my 40s, so I figured I had plenty of time to recapture whatever savings momentum I had lost.
Plus, my high-growth stock fund, where I had parked most of my 401(k) investments, wasn’t performing all that well, certainly not at a 5.75 percent clip, so I didn’t mind diverting these underperforming assets toward my new lustrous kitchen.
To cover educational costs
Above, I quoted a 4.25 percent (3.25 percent prime + 1 percent) 401(k) interest rate. That compares with a rate of 4.66 percent, as of July 1, for a direct subsidized student loan. If you’re a graduate student, the interest rate is 6.21 percent. Of course, if you defer your student loan payments until you find a job, your loan balance will only increase.
While average student loan debt is now about $20,000 per graduate, many alumni are carrying heavier debt loads loads at even higher percentage rates. So, if you have the opportunity to pay off a nagging student loan at, say, 7 percent or higher, you should kill it off, no questions asked, using your 401(k).
By the way, if you’re curious why the IRS makes you pay yourself back with interest, credit the bureaucrat who didn’t want you to entirely gut whatever retirement savings you had managed to scrape together. Paying yourself back with interest softens the blow of self-borrowing.
To pay for a special occasion
If you don’t have a war chest or emergency fund to raid for a special event, you should consider tapping your 401(k). When we say “special event,” we don’t mean running out to buy a 70-inch high-def television set, either.
We had in mind maybe an engagement ring (average cost of 5,000) or even a wedding (average cost of $18,000). Again, you don’t have to turn to any super calculator to see how you might come out ahead. If the cost of interest charged on a consumer loan is 8 percent and the investment earnings you lose from your 401(k) withdrawal is 7 percent, you gain a 1 percent cost advantage.
Not all wine and roses
First, if you have to raid your retirement savings for any reason, you need to take a hard look at what brought you to this fiscal cliff. Have you been spending too much? Are you not following your budget? Do you even have a budget for living expenses, including a rainy day fund to cover life’s emergency of the month?
Second, when you begin repaying yourself back, you still need enough cash flow to afford your other payments such as your mortgage and car payments.
Third, while you might even come out ahead financially if you withdraw funds when stocks and bonds in your 401(k) are underperforming, your financial future could take a sizable hit if you pull funds in a breakout year, such as 2013 when the S&P 500 stock index returned a whopping 30 percent.
And of course, if you lose your job, then most likely you’ll have to pay back your loan within a short specified time (usually 60 days). If you don’t meet that deadline, your loan will be treated as a withdrawal or taxable distribution, and you could pay a 10 percent federal tax penalty on the unpaid balance, if you are under age 59.5.
Finally, your 401(k) loan is not tax deductible. In other words, your 401(k) loan does not offer tax deductions for interest payments, unlike most types of mortgages, home-equity loans and lines of credit. That’s why, despite how easy it is to tap your 401(k) funds, it’s best to consult your tax adviser or financial consultant before taking out such a loan.
Once it was considered a sin to raid your 401(k), regardless if you were faced with a big medical or tuition bill, the threat of foreclosure or the business opportunity of a lifetime. But it’s no sin to put hard-earned money to work sooner than later, especially if you’re still relatively young and there’s a disciplined plan (your employer will insist on it) to repay your loan.
And when you pay yourself back — at interest, no less — you might even feel good about having gotten away with the heist of a lifetime.