Finance experts often advise against borrowing from your 401K or other defined contribution retirement plan because it could put your retirement at stake.
“When your 401(k) or IRA becomes an ATM, you lose out on all the money you would have earned with compound growth,” according to the Ramsey Solutions blog.
People sometimes use a 401(k) loan to pay off higher interest debt, like credit cards. “[Y]ou can’t borrow your way out of debt,” the Ramsey blog points out. But a new research report from the Employee Benefit Research Institute (EBRI) and J.P. Morgan Asset Management revealed that it’s not always a bad idea to borrow against your 401(k), especially if you’re paying off higher interest debt or building assets.
“This research found that higher debt can have a long-lasting impact on retirement security, since higher credit card utilization is correlated with lower 401(k) plan contributions and account balances,” said Michael Conrath, chief retirement strategist, J.P. Morgan Asset Management, in a press release.
Who is taking out retirement loans?
The report found that 9.7% of workers who could take out a plan loan did. The likelihood of taking out a loan increased with age for participants through their 40s, with 12.4% of participants between the ages of 40 and 49 taking out a loan. It then began to decline, with 11.7% of people ages 50 to 59 taking out a loan, and 6.4% of people over 60. By generations, Gen X, which spans the ages of 45 to 60, had the highest instances of loans, with 12.3% of this cohort borrowing from retirement accounts. It’s possible that Gen Xers with 10 to 15 years left until retirement are borrowing to put themselves in a better position to retire with lower expenses by eliminating medical debt or high-interest credit card debt.
Reasons people take out retirement loans
There are often logical reasons to take out a retirement loan. Let’s explore some of them.
Paying down high-interest debt
The study found that only 6.9% of plan participants with no outstanding credit card balances took out a loan. Meanwhile, that figure jumped to 19.8% in households with credit card balances equal to 80% to 100% of their available credit. If taking out a defined contribution plan loan can help you enter retirement with no credit card debt, that could free up hundreds or even thousands of dollars a month, allowing you to enjoy your retirement. The study also showed that households with high credit card usage also had lower average contribution rates to their 401(k) or similar plans. For instance, participants in their 50s with high credit utilization contributed an average of 6.5% compared to 7.6% for those with lower (or no) credit card balances. By paying off your credit card debt with a low-interest loan, you can take the money you’re saving and increase plan contributions, too.
Health care costs
The survey revealed that households with an increase of more than 10% in healthcare costs for the year were more likely to take out a 401(k) loan. The numbers increased amongst Gen X (52.2%) and Boomers (55.2%). Amongst Gen X and boomer households who identified as “financially stressed,” that number rose to 57.1%. Although the survey doesn’t state the loan was used specifically for healthcare costs, a low-interest retirement loan can help borrowers avoid entering retirement with medical debt or even using credit cards to cover rising healthcare costs.
Paying for a new home
Many plan participants who took out a mortgage for a house also took out a retirement loan in the same year, according to the study. More than 15% of Gen Xers who took out a mortgage also took out a retirement loan, the largest of any cohort. By age, people ages 35 to 49 were the largest group to take out a retirement loan (14.9%), possibly indicating that younger Gen X may be borrowing from their retirement to finally fulfill their dreams of home ownership.
Understand the IRS rules for 401(k) loans
Before you borrow against your 401(k), it’s important to understand the IRS rules.
- You can only borrow up to 50% of your vested account balance or $50,000, whichever is less
- You must repay the loan within five years in most cases (unless you’re borrowing money to buy a primary residence)
- You must make payments quarterly (at least)
- If you leave the company for any reason or if the company terminates the plan, you must repay the loan or pay early withdrawal penalties
Pros and cons of retirement loans
Knowing what’s involved, should you take out a retirement loan to help cover living expenses, reduce high-interest debt, or buy a home? Here are the pros and cons.
Pros
- Paying off high-interest debt may leave room to increase contributions
- If you use a loan to buy a home, you can build equity that can help your retirement
Cons
- If you lose your job, you could pay penalties on the loan
- The borrowed money is not growing in your retirement account
- Loan payments will reduce your available income
Other options to explore
If you’re in a bind and have at least five years until retirement and a secure job, taking out a 401(k) loan can help improve your finances.
But there’s always room for course correction, too, if you struggle with everyday expenses.
“[T]he availability of emergency savings to help cover expenses can be a critical factor in preventing or stalling a cycle of increasing debt that can significantly impact retirement readiness,” J.P. Morgan Asset Management’s Conrath said. “Furthermore, the finding that many participants have spending increases on health care when taking a plan loan suggests that examining the health savings and spending accounts available to DC plan participants could also help improve finances, showing the intersection of health and wealth.”
As always, each household financial details are different, so check with your own financial advisor to discuss your specific situation.
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