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Beware: Taking a loan from your 401(k) does come with risks

CNBC logo CNBC 6/30/2018 Sarah O'Brien

© Provided by CNBC For some workers, a 401(k) plan loan seems like a perfect way to access money: You borrow from your own account and repay yourself with interest.

Yet if you’re considering joining the ranks of borrowers, you might want to think twice.

“A 401(k) loan can sound appealing, but taking a loan from your account can have a negative impact on the success of your retirement plan,” said Ryan Fuchs, a certified financial planner with Ifrah Financial Services.

Each year, about 11 million workers turn to their 401(k) plan to fund everything from major financial emergencies to vacations to paying down high-interest debt. And while tapping that pot of money can take care of an immediate issue, the loan comes with risks.

While not all plans allow loans, many do. And the larger the company is, the more likely it’s permitted: 90 percent of those with 1,000 or employees allow them, according to 2017 data from the Employee Benefit Research Institute.

At year-end 2015, 18 percent of all eligible 401(k) participants had loans outstanding against their accounts, down from 20 percent at year-end 2014, the research shows.

Federal law allows workers to borrow up to 50 percent of their account balance, with a maximum of $50,000. The loan is tax-free and, unlike with most outright distributions, there is no early-withdrawal penalty of 10 percent if you’re under age 59½.

Borrowers are given up to five years to pay back their loan, which comes with an interest rate that typically is lower than other with other borrowed money, such as credit cards.

However, some financial advisors say the appeal of these loans only masks the downsides.

First, depending on your plan’s rules, you might be banned from making new contributions to your account for six months. This means you won’t benefit from pre-tax contributions that lower your taxable income.

Additionally, you’ve taken a portion of your retirement savings out the market.

“You’re selling shares and receiving the cash, which means the shares are no longer there growing in value,” said Ric Edelman, chairman and CEO of Edelman Financial Services.

Also, unlike 401(k) contributions, loan payments are made with after-tax dollars. So is the interest you’re paying on the loan.

Remember too, that those loan payments are yet another expense for your budget to absorb. This can be problematic if being short on cash was a reason for the loan.

“Ask yourself if you can afford the payment,” said Monica Dwyer, a CFP with Harvest Financial Advisors. “It will come out of your paycheck and there’s no wiggle room on the amount.”

And if you leave your job — whether due to choice or not — the loan balance becomes due. While you now get until tax time to put the equivalent in a rollover individual retirement plan or a 401(k), it might be tricky to come up with that amount, depending on how much you still owe. (Before 2018, you were generally given 60 days to come up with the balance.)

If you don’t come up with the cash by the time your federal return is due, the loan morphs into an early distribution and is generally subject both to income taxes and the 10 percent early-withdrawal penalty if you’re under age 59½.

Although many financial advisors say 401(k) loans should be off-limits entirely, others say it can sometimes make sense.

“I’ve seen where people might be in a bad situation, like they lost a loved one or they’re about to lose their home, and they feel like there’s no other option,” Dwyer said.

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She also has seen some fairly frivolous reasons for wanting to pull money out of a retirement account — such as installing a basketball court or swimming pool — whether through a loan or outright early distribution.

Credit-card debt is cited as the top reason people take a 401(k) loan, according to research from Fidelity Investments.

Edelman at Edelman Financial Services, who believes all 401(k) loans are a bad move, said that on top of the short-term risks, the long-term implications are the biggest problem.

“You’re going to encounter many financial challenges in life and there will always be temptations to borrow money from your 401(k),” he said. “But if you divert that money away from your savings now, you will regret it in retirement.”

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