July 31, 2018

Practical Planning: Understanding 401(k) Loans

A recent survey of millennials has been making the rounds on news sites, with particular attention focused on 401(k) loans used to finance home purchases. The survey found that two in ten Millennials who plan to buy a home expect to dip into retirement accounts to fund their purchase and that three in ten who are currently homeowners have already done so.

Although 401(k) loans have some advantages, there are also several important factors to keep in mind before borrowing from your future.

401(k) loans have competitive rates, but come with limitations

401(k) loans are attractive because they don’t require a credit check, borrowers don’t need a strong credit score to get a competitive rate, and loans have low or no application fees (though 401(k) loans may have initiation and/or maintenance fees). Loans, however, if they are allowed by a plan, are generally limited to the lesser of $50,000 or one half of your retirement plan balance. Loans must be paid back within five years, unless they are used to purchase a home, in which case the length of the loan may be longer. However, the home buyers’ extension has one significant caveat — you must continue working for your employer.

401(k) loans are dependent on employment

One of the largest risks you face with a 401(k) loan is leaving your employer during the term of the loan, which would force you to make a lump-sum repayment. After separation from service, your full loan balance will be due by the tax filing deadline for the year in which you left your employer. It is also important to read and carefully understand your loan’s repayment provisions. Some employers will not allow additional contributions toward your loan balance — meaning your only two options are (1) the initially scheduled payment plan or (2) lump-sum repayment.

Although you are paying yourself back, you lose out on investment growth

When you take a 401(k) loan, repayments — including interest — are deposited back into your retirement account. Although it is beneficial to be paying yourself back, rather than the bank, you are missing out on investment growth during the time that funds are outside of your retirement account. As a young earner, the greatest force on your side is the power of compounding interest — having a smaller amount of money invested reduces this power and may negatively impact your retirement savings.

401(k) loans are paid back with after-tax money

Even if your retirement account is a pre-tax plan, repayments made on 401(k) loans will be made with after-tax dollars. This leads to double taxation,  as post-tax repayment dollars will again be subject to income tax upon withdrawal in retirement.

401(k) loans can be a useful tool for young earners who are looking to finance a first-time home purchase. They should be entered into carefully, however, and only after serious consideration is given to the loan’s repayment terms and how long you plan to stay with your current employer.