Borrowing from a 401k is a major decision. It is important you make certain considerations before borrowing from your 401k, so that your loan doesn’t negatively impact your retirement.
The key aspect to borrowing from a 401k vs withdrawing from one, is you won’t have to pay taxes or penalties unless you default on your loan or in some circumstances lose your job. If you pay off your debts by borrowing from your 401k you will benefit by paying interest to yourself, instead of your creditors.
If you’re behind on your bills and feel bankruptcy makes more sense, please know your 401k is protected from your creditors. However, if you prefer to avoid bankruptcy or if you’re faced with a chapter 13 bankruptcy, you may find it beneficial to borrow from your 401k to settle your debts.
When borrowing from a 401k, it’s incredibly important to borrow in a way that is conducive to your future. In this article, I breakdown the considerations and calculations you should make when doing so.
How to borrow from a 401k in a make sense way
First consideration, what is the impact to retirement…
The basis for determining if borrowing from your 401k makes sense, is your current and post loan situations.
In the diagrams below you may view examples that encompass the following assumptions – $50,000 401K loan, $100,000 current 401k balance, no employer match, expected annual return of 6%, 60 month loan term, 5% interest on 401k loan, and 30 years till retirement.
Any additional variables in the examples will be cited as they occur.
I used this 401k loan calculator to demonstrate the examples of the costs to retirement savings.
Currently Not Contributing to Contributing
- If you’re currently not contributing to your retirement plan, consolidating your debts may enable you to do so again. Thus, this approach could increase your retirement savings substantially.
Scroll down to the bottom of the image to view the impact to retirement savings.
By going from making no contributions prior to the loan, to making $300 contributions during and after the loan, you increase your retirement savings by $84,339.58.
Currently Contributing to Continuing to Contribute
- If you’re currently contributing to your retirement and can maintain the contribution along with your loan payment, the impact to retirement is generally minimal and can usually be offset by contributing the difference between the interest you paid to yourself and the return you received from your investments.
Scroll down to view the impact to retirement savings.
When making a $300 contribution previous to the loan, and continuing it during and after the loan, the cost to retirement savings at the time the loan is paid off is $2,057.21.
By contributing $2,057.21 to your 401k within 30 days of making your final loan payment or approximately $400 per month for the following 6 months, you should offset all losses to your retirement savings.
If you fail to do so, the loss to retirement savings after 30 years will be $8,651.79.
Currently Contributing to Not Contributing
- If you’re currently contributing and cannot maintain the contribution to your retirement, both during and after your loan, the 401k loan will cost you many times your loan amount in retirement savings.
Scroll down to the bottom of the image to view the impact.
By going from a $300 contribution prior to the loan, to no contribution during and after the loan, you suffer a catastrophic loss of $101,643.15 to retirement savings.
The next consideration when borrowing from a 401k…
What are your interest rates on the debts you want to consolidate?
- Since the interest you pay when you borrow from your 401k is going to yourself, the entire amount of interest you would pay to your creditors is pure savings.
- So, how much is the interest you would pay to your creditors if you paid them off via minimum payments, without a 401k loan?
To make this calculation use a credit card calculator and figure out how much interest you will pay to your credit cards until you pay them off at the frequency you’re currently paying.
In the above example, the assumptions that were used are – $50,000 in credit card debt, 21% interest, 3% minimum payment.
If the minimum payments were maintained throughout the lifetime of the credit card balance, you would spend $25,695 in interest. That is $25,695 you wouldn’t spend in interest by successfully borrowing from your 401k.
The third consideration when borrowing from a 401k is…
The impact to your monthly budget…
- You can project your 401k loan payment by using a loan calculator. When calculating the payment, know that you can get 401k loans with terms that range from 1 – 5 years.
A $50,000 401k loan at 5% interest over a 5 year term has a monthly payment of $943.56. If you were to payoff $50,000 in credit card debt, that had 3% minimum payments, you would reduce your monthly expenses by $556.44.
If that isn’t a large enough reduction, you may want to consider settling your debts with your loan from your 401k.
If you settle, you will reduce the amount needed to resolve your debts. If you could settle your $50,000 in credit card debt for $25,000, your 401k loan payment would be $471.78. Reducing your monthly expenses by $1,028.22 instead.
- Another consideration to make, is the maximum you can borrow from a 401k loan is $50,000. Let’s say you have $100,000 in credit card debt, a 401k loan for $50,000 may not lower your monthly payments enough to solve your problem. If it doesn’t, you may want to consider settling your debts with your loan from your 401k.
- Your final consideration regarding the impact to your monthly budget is… is the payment affordable and sustainable?
The key to successfully borrowing from your 401k is affordability. It is crucial you can comfortably afford the 401k loan payment going forward.
If you have an ounce of doubt, don’t borrow from your 401k.
Your final considerations when borrowing from a 401k…
If you feel the loan makes sense and creates an affordable monthly budget for you, your final considerations will be about risk.
- If you default on your loan, it will convert to a withdrawal and you will have to pay a 10% penalty, along with state and federal income taxes.
- If you lose your job while your loan is outstanding, you may have to repay the loan back within 60 days of job separation. If you’re unable to do so, your loan may convert to a withdrawal and become a penalized and taxed event.
However, some employers will allow for the continuation of the loan after job separation, so it’s worth looking into your employers policies regarding this prior to making your loan.
- Another risk you should consider, is running up your debt again. If you pay off your debt, your credit lines will be freed up and available. If you borrow from your 401k, it is highly advisable you remain disciplined and only utilize unsecured credit when necessary going forward.
If you are uncomfortable with any of the risks, you should not borrow from your 401k.
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