I generally regard financial advisers to be smart people when it comes to money. Since they almost universally warn against taking out a loan against a 401k plan, I tend to think they must know what they’re talking about. Recently, however, research has come out indicating that borrowing money from your retirement account can actually be a smart financial decision.
One case where you can actually save money by taking out a loan on your 401k retirement plan is to pay off high-interest credit card debt. You are basically trading high-interest credit card debt for low-interest loan debt. Research also indicates a secondary benefit. If workers know that cash is available in the form of a 401k loan, they are inclined to contribute a greater amount of money to their retirement savings. But before you run off to trade in your retirement savings for that 60 inch HDTV, you should consider the serious risks involved.
Your employer’s specific 401k plan
Before borrowing money from your 401k, you should become very acquainted with your company’s specific plan. Company retirement policies differ, so it would be wise to seek advice from your company’s counselor, a credit counselor, or even possibly a bankruptcy attorney. You will likely find that borrowing money from your 401k retirement plan involves accepting certain fees and restrictions. Likewise, though federal law allows an account holder to borrow as much as half of his account balance, your company might place other limits on how much you can borrow.
Another important factor to consider is how stable your job is. In most cases, if you are fired or leave your job, you have to repay your loan within 60 days. This can create tremendous problems if you took out a sizable 401k loan. If your job security is in question, you might want to leave your retirement funds where they are.
Even if taking out a 401k loan makes all the sense in the world numerically, it still might not be a good idea. If you don’t have a clear cut plan to pay back your loan, you could end up back where you started, burdened by expensive debt. Setting up an automated saving system might help you repay the debt by ensuring that part of your monthly paycheck goes straight to paying back your loan.
Contributing to your 401k while repaying the loan
Even though you took out a 401k loan, it definitely does not mean you should stop making regular contributions to your retirement fund. One study estimated that if you take out a $30,000 401k loan and stop contributing to your account, it could cost you as much as $600,000 in the long run.
Danger of bankruptcy
If you’re in danger of going bankrupt, you should probably not take out this type of loan. If you go bankrupt, your retirement savings are usually protected. However, if you take out a 401k loan, your money is no longer protected.
A positive example
There are some real and serious risks involved with a 401k loan. However, as the research indicated, making this financial move can be smart in the right circumstance. Zachary Fruhling, a PhD candidate from the University of California, Santa Cruz provides one example of how a 401k loan can be used to save money. Fruhling took out the loan to pay off higher interest credit card debt that he just couldn’t manage to pay off. Since Fruhling was a student, he didn’t have to worry too much about suddenly losing his source of income and having to pay the loan back in 60 days. Fruhling had his loan payments automatically deducted from his paycheck. That way he wasn’t at risk of failing to make a payment or spending the money on something else. Lastly, Fruhling had a long-term plan in which he knew he could pay off the loan fairly quickly, while continuing to contribute to his retirement account.
While there are risks involved in a 401k, don’t be too quick to throw the idea to the wayside. There are some situations, like Fruhling’s, where taking out a 401k loan is a smart, though unconventional, idea.
Published or updated January 30, 2012.