Over the past few years you've cheered the increase in your 401(k) balance fueled by steady contributions and new market highs.
But in spite of making great strides in your net worth, you may feel strapped. You may have a six-figure retirement plan, but not be able to pay for higher education, the overdue kitchen renovation or a down payment on your new home.
Borrowing from your 401(k) would allow you to access your cash and put it to work to improve your life today.
While the terms can differ depending on your employer, a retirement plan loan generally works like this. You notify your plan administrator that you want a loan against the balance of your plan. You can borrow up to $50,000 or 50 percent of the value of your balance, whichever is less. Once you receive a check, your 401(k) statement shows the loan as one of the investments.
No longer can that portion of your retirement plan be invested in a stock fund or other type of investment. Instead you are "invested in yourself."
With most loans, you get five years to pay back the balance, usually through automatic paycheck deductions. If the loan is to acquire a personal residence, you may have 10 years. The interest rate is set by your particular plan and is often 1 to 2 percent in excess of the prime rate, which currently is 3.25 percent.
There are plenty of positives to ponder. The interest rate is low compared to other loan options, which can be 9 percent for a personal loan or 15 percent for a credit card. You don't go through underwriting, so a middling credit score will not impede your access to cash.
The best thing about a 401(k) loan, supporters argue, is that you are paying interest to yourself. Now that bond prices are suffering significant declines and interest rates are paltry, a guaranteed 4.25 percent (from yourself) investment sounds pretty good.
In spite of these benefits, many financial experts think retirement plan loans are toxic. They state that 401(k) loans prevent you from investing in equities that will grow over time for retirement. They argue that you must pay back loan balances in case of job loss, disability or death.
If you're not able to pay the balance, it will be considered an unqualified distribution fully taxable as income plus a 10 percent IRS penalty if you're under 59 1/2. And many say that you're forced to pay taxes on a 401(k) loan twice because you must use after-tax dollars to pay off the loan balance. (This last argument is hogwash as paying interest with after-tax dollars is true with most loans.)
Is a 401(k) loan for you?
First, your employment must be very stable. You want to avoid paying tax and penalties that could come from job separation.
Second, keep contributing to your 401(k) at the same rate even though you will be making loan payments.
Next, consider your loan to be a bond in your retirement plan. You don't want to supplant the potential growth of a stock fund. Plus, you must reconsider if the loan will be used to support spending beyond your means or if you may be headed toward bankruptcy. Your retirement plan balance is protected from creditors, but the amount borrowed from the plan is not.
Finally you should exhaust other low interest loan options such as a home equity line or a car loan before you dip into your 401(k).
A retirement plan loan is not for most, but it's viable option in limited circumstances.
David Gardner is a certified financial planner with a practice in Boulder County. He can be reached at yellowstonefinancial.com.