Why Borrowing Money From Your 401(k) or IRA Is a Bad Idea

Taking money out of your retirement funds should be your last option.
Author:
Publish date:

The number of Americans filing for unemployment rises weekly as businesses remain shuttered indefinitely to lower the spread of the coronavirus, resulting in 22 million people that are out of work.

The U.S. Department of Labor said that 13.5% of the labor force filed jobless claims since March 14. Depending on the state, obtaining unemployment funds has been challenging. Consumers have sought temporary reprieves from mortgage and auto lenders, landlords and other creditors such as credit card companies and student loan lenders for the next 90 to 120 days.

Those deferments are a temporary salve for consumer budgets as their emergency cash levels are dwindling quickly.

Borrowing money from your retirement funds such as a 401(k) plan or IRA has always been frowned upon by financial advisers and experts, but many consumers are faced with very few options.

401(k) Loans Are Interest-Free

As job losses increase, some households may need to consider borrowing from their 401(k) because this option is much less expensive than other ones, such as a personal loan, payday loan or incurring debt on credit cards, said Stuart Michelson, a finance professor at Stetson University in Deland, Florida.

“There is generally no cost to borrowing from your 401(k) other than perhaps an administrative fee,” he said. “Many investment firms have made it easy to borrow from your 401(k) through a website or debit card.”

Borrowing funds from your 401(k) is not considered a traditional loan because your credit score is not checked and a lender is not involved. 

The CARES Act states that people who are directly affected by the coronavirus or taking care of affected family members can lean on their retirement accounts to help alleviate short-term financial stresses such as paying their mortgage or for necessities such as food and medicine.

Rules have been relaxed for coronavirus-related withdrawals and individuals can now borrow as much as $100,000 or 50% of their 401(k) without paying the 10% penalty, whichever amount is higher.

“On a typical loan, a borrower pays interest, but typically there is no interest on a 401(k), but instead there is an opportunity cost,” Michelson said. “The borrower loses the benefit of any investment return on the borrowed funds until they are repaid.”

Money to repay the 401(k) loan is repaid with after tax dollars, compared to the investment into the 401(k) as contributed with pretax dollars.

One alternative repayment method is to discontinue your current 401(k) contributions but continue the payroll deduction to repay the 401(k) loan, he said.

“You are losing the benefit of new investment in your 401(k) plan, but you are more assured of the loan being repaid,” Michelson said.

Employees could be on the hook for paying taxes and penalties if they are under 59½ years old and leave or lose their current job. Under the CARES Act, the loan repayment amount has been extended to one year, compared to the previous period of 60 to 90 days.

One advantage of taking a loan from a 401(k) is because it is an interest-free loan, said Mike Loewengart, managing director of investment strategy at E-Trade Financial  (ETFC) - Get Report, a brokerage company in Arlington, Virginia.

“Essentially, you’re borrowing from yourself,” he said. “Your assets stay invested and can continue to compound.”

Under the new laws, if your employer plan allows you to take a loan from your 401(k), you are allowed up to $100,000, but you’ll have to pay the loan back within six years.

“If your financial future is somewhat stable for the next few years, the 401(k) loan should be the first avenue to explore,” he said.

Taking Money From Retirement Funds Should Be Your Last Option

People who are contemplating a withdrawal should consider the long-term implications compared to the short-term benefits. Market volatility this month might have spurred losses in retirement accounts and individuals who choose to withdraw from an IRA are effectively locking in their losses and forfeiting future tax-advantaged opportunities to grow their wealth, Loewengart said.

“Many Americans are facing economic hardships amid the coronavirus pandemic and making big financial decisions in times of uncertainty can be difficult,” he said. “But even though you can do it, doesn’t mean you should.”

Before you withdraw money from your retirement account and lock in the losses, consider your entire financial picture.

“Make sure you’ve exhausted all the ways you can cut back on your expenses, such as refinancing to take advantage of the lower interest rate environment,” Loewengart said. “Though it may seem daunting right now, those cutbacks could add up to help make important payments.”

While the removal of the 10% withdrawal penalty may make it seem more attractive to borrow from a 401(k), there are a number of potential drawbacks, said Molly Passantino, senior specialist of retirement and annuities at TD Ameritrade, an Omaha, Nebraska-based brokerage company.

“Keep in mind that you are still responsible for paying taxes on your withdrawal, which you would need to do regardless of timing if you have a traditional 401(k),” she said.

People are still losing the compounding interest and the benefits of investing early, Passantino said.

“With the current economic environment, it is highly likely that your 401(k) and/or investment accounts have already lost money based on the value of their underlying investments,” she said. “Coupling this loss with a withdrawal, however, puts your balance even lower and makes it harder to recoup your original investment.”

Turning to the money accrued in your Roth IRA is another option because the contributions you made can be withdrawn at any time without having to pay taxes or penalties. Avoid withdrawing money that was accrued from your earnings or you face the 10% penalty.

One benefit of a Roth IRA is that you can pay back the money you borrowed as long as it's within 60 days in the same Roth IRA or another IRA, serving as a short-term emergency savings account. The catch is that the IRS only allows this once a year.

“With a Roth IRA, you are able to withdraw your contributions, not the earnings, at any time for any reason, without paying taxes or penalties,” said Greg McBride, chief financial analyst for Bankrate, a financial data company in New York. “If you absolutely have to pull money from your retirement account, look to your Roth IRA first.”

Pulling money out of your retirement account should truly be a last resort, he said.

“The $10,000 withdrawal you make today costs you $57,000 if you look at what it could be worth 30 years from now, not to mention the tax bill you’re stuck with on that $10,000 withdrawal,” McBride said.

Borrowing money from a credit card, taking a distribution from a 529 plan or obtaining a HELOC, or home equity loan, for a short period of time could be additional  options.

“Borrowing, even at a relatively high interest rate but over a shorter period of time, will cost less than the long-term cost of pulling money out of retirement accounts,” McBride said. “Unfortunately, the easiest time to borrow is when you have a job and don’t need a loan, so if a personal loan, home equity line or a credit card isn’t an option, look to family members or friends that may be able to lend you money on more favorable terms. But tread carefully, as you don’t want money to ultimately undermine family harmony or your friendship.”