But plenty of people do it anyway, so here are nine tips on how to do it responsibly.
1. Don’t use your 401(k) as an ATM
The main purpose of a 401(k) plan is to enable you to be prepared for retirement. But the minute you start using the plan for a different purpose, you run the risk of diluting or even short-circuiting that objective.
For example, because it’s so easy and convenient to borrow from your 401(k) plan, you might become a serial borrower. As soon as one 401(k) loan is paid, you’re already submitting the paperwork for another. And if your plan permits it, you might even have more than one loan going at a time.
After all, under IRS rules you can borrow up to 50 percent of your vested balance in the plan, up to $50,000. You might be tempted to take a new loan every time your vested balance increases by a few thousand dollars. At that point, your 401(k) is functioning primarily as an ATM.
If you do take a 401(k) loan, never forget the main purpose of the plan. Keep loans to a minimum, and only when absolutely necessary.
2. Just because the term is five years doesn’t mean you should take five years to pay
401(k) plans typically permit you to take loans of up to 60 months. Some plans even allow you to go longer under certain circumstances. But just because you can take multiyear loans, doesn’t mean that you should.
Keep the loan term as short as possible. If you have five years to pay, plan to pay it off in three years. Two is even better. The shorter the loan term, the lower the risks are to you and your plan.
3. Make sure your job is stable
If you quit your job, or are otherwise terminated, and you have an outstanding balance on a 401(k) loan, you will generally have between 60 to 90 days to repay the loan balance in full. If you don’t, the outstanding balance will be considered to be a distribution from the plan. It will then be subject to ordinary income tax. If you’re under 59 ½ years old, you will also be subject to a 10 percent early withdrawal penalty.
If you’re going to take a 401(k) loan, be as sure as you can be that your employment will last at least long enough for you to repay the loan. But since you can never know that for sure, it’s another compelling reason to pay off your loan in as little time as possible.
4. Don’t take a 401(k) loan if you already have a lot of debt
Since they are secured loans, and often paid fully out of ordinary 401(k) plan contributions, you might be persuaded that 401(k) loans aren’t “real debt”.
That’s a really bad assumption. Debt is debt, whether it’s credit card debt, or secured debt, like an auto loan, a home mortgage, or yes, a 401(k) loan. If you already have a lot of debt, taking a 401(k) loan will just put you deeper in.
Also, the fact that you have a large amount of debt in general can impair your ability to pay off your 401(k) loan early. It will also weaken your ability to deal with an emergency situation. Lose your job for any reason, and the 401(k) loan balance would become immediately due and payable.
5. Don’t ignore 401(k) loan fees
Most 401(k) plans charge some sort of administrative fee for creating loans against the plan. If that fee is, say, $100 on a $5,000 loan, it will be the equivalent of paying a two percent origination fee for the loan. That’s a steep cost on an otherwise low-cost loan.
What’s worse is that the fee is charged off the top. It will be drawn out of your plan, and not replenished by the loan payments. That will result in a slight, but permanent reduction in your 401(k) plan balance.
6. You might think you’re just “paying yourself back” when in reality…
This is one of the common justifications for taking a 401(k) loan. Rather than paying interest to a bank or other lender, you’re simply paying interest into your own plan. That means that you’re paying interest to yourself. So far so good.
But here’s the problem: you may be paying yourself and your plan a very low rate of interest.
For example, let’s say that your plan charges you five percent interest on a 401(k) loan. As a borrower, you appreciate the low rate of interest. But as an investor in the plan – which is what you are, first and foremost – five percent is a subpar rate of return on your money.
If you would otherwise earn say, 10 percent on your plan investing in index-based exchange traded funds, then you will be losing five percent per year on the outstanding balance of the loan. Worse, the loss will be cumulative. You won’t be able to “make it up in the stretch”. Earnings lost due to a loan is income lost forever.
Strategy: Avoid taking 401(k) loans; if you do take one, take the smallest balance possible; and always pay the loan off as quickly as possible.
7. Make sure your income and cash flow can handle the payment
If the payment required to pay off the loan within the stated term isn’t covered by the amount of your regular contribution to your 401(k) plan, then you will have to pay extra to make up the difference.
Let’s say that you’re currently contributing $300 per month to your plan. If the payment on the loan will be $400 per month, then the withdrawal from your pay must rise to at least $400 per month.
Make sure that you can comfortably accommodate that increase in your budget. Never assume that it won’t hurt because it’s a payroll deduction, and not a direct loan payment. Whatever you choose to call it, it’s still a reduction in your cash flow.
8. Have a back-up repayment plan in place
We’ve already discussed how the balance on a 401(k) loan can suddenly become due if for any reason your employment ends. But there’s a second situation that can create the same outcome. If your employer decides to end the 401(k) loan program, your loan balance will similarly become due and payable.
The problem with either situation is that it can develop quickly, and without warning. You would have to have a plan in place to deal with that outcome. If you don’t, it will be distribution time, and that will cost you taxes and penalties.
That would mean either having liquid savings available, or having access to a credit line that’s sufficient to pay off the 401(k) loan.
A lot of people maintain both a 401(k) plan at work, and an outside plan, like a traditional or Roth IRA. But if you don’t have the liquid assets or credit lines to pay off your loan balance on short notice, it makes little sense to fund an IRA plan. If you do, you’ll be building your IRA at the same time that you’re carrying the loan risk on your 401(k) plan.
The better strategy is to devote the funds that would go into an IRA into paying off your 401(k) loan as soon as possible. Once you do, you will be restoring your 401(k) plan to maximum efficiency. You can then fund your IRA account without putting your 401(k) at risk.
The best strategy when it comes to 401(k) loans is not take them at all. But since you’re probably going to do it anyway, make sure that you do it responsibly. Follow these nine tips, and you’ll at least minimize the potential damage that 401(k) loans cause.
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