Borrow From Your Retirement: Yes or No?
The other day a reader of our blog, whom we will call Anna Nimmity, asked if it is a good idea to take a loan out on her 401(k) to pay off $10,000 worth of credit card debt. Our immediate response was no! Unfortunately, we did not have time to immediately elaborate and in the meantime Anna took out a loan. Though she appreciated our advice, she now has peace of mind having paid off her debt. Peace of mind cannot be overlooked. As pragmatists, however, we cannot help but think the regret will follow.
There are two ways Anna could have taken money from their 401(k). She could have taken a premature distribution or she could have taken out a loan, as she did. There are drawbacks to both and we will ex-plain and allow you to decide if you should borrow from your retirement.
A 401(k) distribution is premature when the account owner is under the age of 59 and a half. Premature distributions carry a penalty of 10 percent on the distribution amount. In addition, because the premature distribution money was not taxed when it was initially deposited into the 401(k), it is taxed the same year of the premature distribution.
Based on what we know, Anna likely falls into the 25 percent tax bracket. This means she would have to pay a total of 35 percent of the premature distribution (10 percent penalty + 25 percent taxes = 35 per-cent total).
Because of the circumstances, we can assume Anna does not have the cash to pay this 35 percent to Uncle Sam. Most likely, she withdrew additional money from her 401(k) to pay the taxes and penalty. In order to have enough money to cover both charges and receive her $10,000 she would’ve needed to withdraw $15,385. $1,538 would need to have been withdrawn for the penalty and $3,847 withdrawn for taxes.
Let’s take into consideration the opportunity cost of the $15,385. An opportunity cost is what could be done with money as an alternative to what is actually done with it. In this case, the opportunity cost would have been to keep the $15,385 in the account and let it grow. Let’s assume that Anna has 20 years until retirement. Her opportunity cost would have been the investment growth of $15,385 over 20 years. Invested in a moderately conservative portfolio that returns 6 percent, her $15,385 would have grown to $49,342 in 20 years.
Anna’s total cost for the premature distribution would have been $49,342.
Anna ultimately took a loan out on her 401(k). This can be a more economical option to pay off credit card debt. Let’s take a closer look.
Anna took out a $10,000 loan from her plan and paid off her debt. Unlike the premature distribution, the $10,000 loan must be reimbursed to her 401(k) and it carries with it an interest rate that must, also, be paid to her 401(k) account.
Most people make their repayments over a long period of time. Per Anna’s plan, she will repay her loan over ten years. Let’s assume the interest rate on her loan is 6 percent. This comes to a $111 monthly payment. That seems easy. Here is the kicker, though. Taxes must be paid on interest on a 401(k) loan.
On Anna’s 10 year, $10,000 loan, her interest expense will be $3,323. Because Anna is in the 25 percent tax bracket, the taxes that she will pay on her $3,323 interest expense will be $831.
Even after Anna refunds the $10,000 loan to her 401(k) and pays interest and taxes on her interest, she is not done paying Uncle Sam. She must pay more taxes when she withdraws this money again in retirement, thereby increasing her net expense.
To calculate the future taxes Anna will pay on the future growth of the $3,323 that she puts back into her 401(k) is too complicated for this post. For the sake of brevity, her taxes on this growth will be approximately $1,247.
Anna’s total costs on the 401(k) loan will be about $2,078.
Retirement accounts are often our accounts with the highest balance. It is very tempting to tap into these accounts when we need money. As you can see in both the examples above, tapping a 401(k) is costly.
Were there better options for Anna? Should she have gone with a conventional loan or a consolidation loan?
We hope that the examples above put context around withdrawing and borrowing money from a 401(k). If you are in a similar situation as Anna, we recommend you explore all available options and determine which option works best for you.
Use Bankrate’s “Should I Borrow From My 401(k) Plan” calculator to get an estimate of what your costs may be. We accept that all cases are not the same. Therefore, crunch the numbers for your situation and let the numbers dictate what to do.