Should You Borrow From Your 401(k)? | American Funds

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January 30, 2017

Should You Borrow From Your 401(k)?

An increasing number of Americans are tapping into their retirement plans when they need cash. While it may be unavoidable, here are a few things to consider before taking that step.

13% — Percentage of Americans who borrowed from a retirement account in 2015

Need cash? Many Americans do — and some are turning to their 401(k)s to get it.

In a survey of some 27,000 U.S. adults, 13% reported that they had to borrow from a retirement plan in 2015. The study, “Financial Capability in the United States 2016” by the FINRA Investor Education Foundation, considers this a sign of financial stress, much like taking a hardship withdrawal from an IRA or missing a mortgage payment.

Most employers allow employees to borrow from their retirement plan accounts, and when used responsibly or when other options have been exhausted, these types of loans can be an appropriate alternative.

Under IRS rules, the maximum amount a plan can allow as a loan is (1) the greater of $10,000 or 50% of the vested account balance, or (2) $50,000, whichever is less.

The loan must be repaid within five years, unless the proceeds are being used to purchase a home — in which case the period can be extended significantly. Most plan sponsors require that you pay back the money in substantially equal payments (that include both principal and interest) via payroll deductions.

Taking a loan, however, comes with certain consequences. The money you’ve withdrawn is no longer growing, and your repayments are made with after-tax dollars.

Perhaps the biggest risk you face when borrowing from a 401(k) is the possibility that you might lose your job or choose to quit unexpectedly.

If that were to happen, the entire loan balance would become due — in some cases immediately. If you can’t or decide not to repay the loan at that time, it is then in default and the remaining balance would be considered a withdrawal (on which you’ll owe taxes). What’s more, unless your separation from service occurred during or after the year you reached age 55, the loan withdrawal amount will be subject to a 10% early withdrawal penalty.

How often does this happen? An estimated one in 10 retirement loans are not repaid. This typically occurs when a worker leaves his or her current job, according to a 2014 study by the Pension Research Council of the Wharton School at the University of Pennsylvania, “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults.” This isn’t surprising considering the average person will change jobs 10 to15 times during his or her career, according to the Bureau of Labor Statistics.

The bottom line: While taking a loan may be necessary to meet an immediate financial need or to make a significant purchase like a home, never lose sight of your long-term financial security. Ask yourself if spending that money now is really worth it.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.