Saddled with debt or facing a large bill such as one due to the IRS, consumers often turn to their retirement portfolios and take out a 401(k) loan or the principal amount from an IRA.
Financial advisors recommend that Americans refrain from taking out these types of loans against their own retirement savings because making up the difference can be a costly mistake and one that they regret later on.
While borrowing from a 401(k) account appears to be a quick solution when consumers are cash-strapped, financial advisors tend to steer their clients away from this option. Although 401(k) loans do not require a credit check unlike obtaining a credit card or personal loan, employers will typically demand that you repay the loan within a short period if you leave your job or get fired.
The majority of 401(k) plans allows employees to borrow up to 50% of the vested account balance or up to $50,000 at rate based on the prime rate, plus 1% to 2%, which amounts to approximately 6%, said Jon Ulin, a managing principal of Ulin & Co. Wealth Management in Boca Raton, Fla. Qualified retirement plans typically require that the loans need to be repaid within a five-year period.
"The interest is paid back to your 401(k) account and not to the plan sponsor," he said. "As you are really paying the loan interest cost back to your own account, it really is not an expense such as taking a cash advance from a credit card or home equity line of credit."
Borrowing from your retirement portfolio is frowned upon because there is a hidden opportunity cost of employees missing out on growth from their monthly investments. It can "have a direct effect on your future retirement nest egg," Ulin said.
A study conducted by the Employee Benefits Research Institute (EBRI) found that since 2000, nearly 20% of all 401(k) participants still had outstanding loans.
"We have also seen many employees who take out 401(k) loans reduce or completely stop their retirement savings contributions while the loan is outstanding," he said.
Raiding funds from your 401(k) can result in high "opportunity costs" since a moderate to moderate aggressive allocated portfolio could return an average of 6% to 8% per year, Ulin said.
The opportunity cost of not investing $50,000 for one year is about $3,000 to $4,000 in tax-deferred gains in your 401(k), he said.
"Based on the rule of 72, your money could double every ten years with just a 7% return, so you could be costing your retirement nest egg double what you are taking out if you decide to not pay it off and take a taxable distribution, plus an applicable penalties if you are younger than 59.5," Ulin said.