Episode Transcript
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Car broken down? Got high-interest credit card debt? Or maybe you're looking to buy a home. Does a 401(k) loan make sense for you and your family?
It depends. Emergency expenses are going to come up. We all know life happens.
Walk us through the pros and cons.
Money is going to start coming out of your paycheck right away.
Map that out for me.
Really think about why you are taking a 401(k) loan in the first place.
I need money. I don't have enough in the bank. What if I want to borrow it from my 401(k)? That's the question we'll answer on this episode of Money Unscripted, a podcast from Fidelity Investments.
Hi. I'm Ally Donnelly. Maybe you need a home repair or have medical bills or want to pay down those high-interest credit cards. Taking out a 401(k) loan could be an option, but there are pros and cons to weigh before making that decision, including how it could affect your retirement.
Let me welcome Mike Shamrell. Mike is a Vice President here at Fidelity, and he's going to walk us through everything we need to know. Mike, thanks for being here.
Thanks for having me.
So there are lots of reasons someone might consider a 401(k) loan, but what should they weigh, big picture, before diving in?
They probably want to look at exactly what the expense is that they're trying to address with their 401(k) loan. Is this something that is an immediate expense that needs to be addressed right away, or is this something that maybe they can't afford right now and they should probably consider saving up for to purchase or to address at a later date?
But if you have something that is an immediate need, something you need to address right away, and you don't have any other savings options, 401(k) loan could be a good option to consider for you.
Give me some examples.
So let's say you need your car to get to work and your car breaks down. That is something you need to address right away. That's not something you can save up for and address in a couple of months.
Let's say you have little kids at home and your refrigerator goes on the blink. That's not something that you can save up for. That's something you need to-- you need a new refrigerator right away. And so, again, if you don't have any other savings options, those are the types of situations where you might want to consider 401(k) loan, some type of expense like that.
Other expenses, vacations, big-screen TVs, your college roommate's bachelorette party in Nashville-- not necessarily the best reasons to be considering a loan from your 401(k).
OK. So we talk about loans, but I also know there are hardship withdrawals. What's the difference?
So a loan, you don't necessarily need to have any reason. You will pay your loan back. And you are somewhat limited in terms of how much you can borrow. A hardship withdrawal is a little different in that you have to qualify for that. The IRS has very specific guidelines where people are eligible for hardship withdrawal or are not. If you do qualify for a hardship withdrawal, you don't necessarily have to pay that back, but you likely will face taxes and penalties on the amount that you can withdraw.
You're not limited in terms of how much you can withdraw through a hardship, but you are limited in terms of taking the amount that's going to cover the expense that you're trying to address.
How much can I borrow, and does-- if I have a 401(k), should I assume I can take a 401(k) loan?
Shouldn't assume. You want to check with your employer because each employer gets to set up the parameters for their individual 401(k) plan. Most employers do allow loans. There might be limits in terms of how many loans you can have out at one time. More and more employers are only allowing you to have one loan at a time.
And then in terms of how much you can borrow, generally, it's $50,000 or half of your balance, whichever is lower. So let's say you have $80,000 set aside in your 401(k). You are limited. You can only take $40,000 out because that's half of your balance. And so it's $50,000 or half your balance, whichever is lower.
How do I pay it back? What are the parameters there?
So we do let people know and remind people that when you do take a 401(k) loan, you're going to have to start paying it back, which means your take-home pay is going to go down.
The loan repayments, similar to your 401(k) contributions, which are automatically taken out of your paycheck and put into your 401(k)-- your loan repayments are automatically going to be taken out as well. It's not a situation where you're going be sending a check through the mail each month.
So you want to bear in mind that you will be-- your take-home pay will go down. You can set the length of time that you want to take to repay it. It's usually no longer than five years, but you do have some sort of flex-- a little bit of flexibility in terms of what the loan repayment schedule looks like.
And you also want to bear in mind that there's going to be interest payments. And that, again, is set by your employer, but in general, it's usually the prime rate plus 1.
OK. So when you say payroll deductions, those start pretty quickly, I imagine?
Yes, yes.
And then I can't pay, like, oh, I'm flush this month, I'm going to pay $5,000, and then, oh, I'm low this month, I'm going to pay $200. It's a set amount.
Right, exactly.
Same set amount.
Yes. So we try to remind people when they're considering a 401(k) loan that that's going to start happening right away, and it's going to be the same amount coming out of their paycheck each pay period.
OK. And you said employers-- some employers are saying one loan at a time. How many loans could I conceivably have at one time?
Well, it all depends on what your employer allows, but let's say you have-- your employer only allows one. This goes back to our discussion about why you want to take one. If you take out a loan for something that might have been just something that you couldn't afford that you probably should have saved up for and you have a loan outstanding, and then all of a sudden, a real emergency pops up-- you've already got a loan out, and you're not eligible to take a second one.
So because more and more plans are only allowing employees to have one loan at a time, it's just another reason to really think about the reason why you are taking a 401(k) loan in the first place.
But the $50,000 limit stands. It's not that I could take 50 October and then wait until January of next year and take another one?
No, you set the amount that you want to borrow for that loan, and until it's repaid, you're not able to take any more, in general.
OK. I've taken out the loan, but I'm paying myself back, and I'm paying myself back with interest. It's going right back into my 401(k) account. So what's the downside?
That's right. You are paying yourself back. The money is going to start coming out of your paycheck right away. And it is with interest. The potential downside is that that money is out of your 401(k), so if there are positive market conditions, that money is not going to be able to grow. So it just, long term, could have a negative impact on your ultimate retirement savings amount.
So if I take out that money, it's not working for me in the same way.
That's right. And again, you are paying yourself back with interest, so all that money, best case scenario, goes back into your 401(k). But for that period of time-- and again, you can set your loan terms to up to five years. That's five years where that money is not going to have the opportunity to grow, which could, under various scenarios, have a negative effect on your ultimate ability to hit your long-term retirement goals and hurt the ability that you're able to save for retirement overall.
Even though I've taken out a loan, can I continue to contribute to my 401(k)?
Absolutely. Yeah. Definitely. There's nothing that's going to restrict you from making contributions. Again, you do want to bear in mind that your take-home pay is going to go down, which-- we'd like to think that that wouldn't have an impact on the ability-- of people's ability to contribute. However, being realistic, we understand that some people may have to dial back on their contribution rate if they're repaying the loan.
What if I leave the job where I was working when I took out the loan or I get laid off or I lose my job?
You are required to pay it back in a very short period of time, usually 30, 60, or 90 days, but no longer than 90 days. If you are not able to pay it back in full, whatever you haven't repaid is viewed by the government as a distribution, which means there's going to be a 10% penalty as well as applicable taxes that you're going to have to pay the following spring.
So that's another thing that we recommend people consider before they take a 401(k) loan, that if they are in some sort of fluid job situation, if they are to separate from their employer, they'll have to pay that loan back right away, usually in 90 days or less.
So your hope is that you're on good footing, but who knows what could happen?
Life happens.
Yeah.
Exactly.
Yeah. So as I think about a 401(k) loan and my credit, does it ding me on my credit?
401(k) loans are not reported to any credit bureaus, so they don't have any impact on your credit score. And in the worst case scenario that you're not able to repay your loan, that you do separate from your employer, that isn't necessarily viewed as a, quote-unquote, "default" on the loan. It's just, again, viewed as a distribution. You will have to pay a penalty and taxes.
But in general, 401(k) loans don't really have any impact on your credit standing, which, again, is something for people to keep in mind as they're considering. If they do have an immediate expense they have to cover, another thing to keep in mind in terms of whether or not they want to tap their 401(k).
But the only way you could miss a payment is if you lose your job or you leave your job, because it's directly taken out of your paycheck.
Yes, it's automatic. Right.
OK. What's the difference between taking a 401(k) loan and any other kind of loan?
So the process of getting a 401(k) loan is usually a bit simpler. You're applying through your 401(k) recordkeeper, and the process is usually a bit more streamlined than going to, let's say, a bank. Another benefit is you're paying yourself back with interest. And then the third is that 401(k) loans aren't necessarily reported to a credit bureau, and so they don't involve the same type of credit risk that taking a loan from an outside financial institution would involve.
Brass tacks, bottom line, is taking out a 401(k) loan a good idea?
So as is the case with a lot of personal finance decisions, it depends. What we try to do is give people things to consider. Again, you don't need a reason to take a 401(k) loan. You are paying yourself back, ultimately, with interest. However, you do want to keep in mind that your take-home pay is going to go down. And if you do for some reason separate from your employment, you'll have to pay the balance back right away.
OK. Let's say I do take the 401(k) loan. What's a future state learning, or how do I put myself in a better position so I don't have to take another one?
We like to use-- whenever someone is considering a 401(k) loan, we like to use that as a starting point for a conversation around emergency funds. We like to encourage people to find ways to develop an emergency fund so that they have a pool of money for when an emergency comes up.
Because as you mentioned, emergencies are going to come up all the time. Life happens. These are unforeseen, best-laid plans-- if you have a pool of money that you can tap into when something like this comes up, that will help prevent you from having to take your 401(k) loan.
Makes sense. OK. So as I'm leaving this conversation, what do you really want me to walk away with as I weigh this option?
So you, obviously, want to make sure that you're taking a 401(k) loan for the right reasons, that it's not for something that may not be in the best interest of your long-term retirement savings. While you're repaying the loan, that money is not going to be in your 401(k), and so it's not going to be able to take advantage of any positive market performance, which in the long run could have an impact on your retirement savings efforts.
Your take-home pay is going to go down as you start making those loan repayments, so you need to work that into your budget. If you're someone who is on a really tight budget and kind of living paycheck to paycheck, you want to keep that in mind.
However, a 401(k) loan, a lot of times, can make the most sense. If you are faced, again, with a very immediate financial need that you need to address and the choice is a 401(k) loan or a high-interest credit card or a payday loan or some other source that might not be in the best interest of your personal financial decision, a 401(k) loan, if you're eligible for it, could be a very viable decision to help you address whatever that financial need is that you're facing at that time.
Terrific. Mike Shamrell with Fidelity, I thank you so much.
Thanks for having me.
If you're looking for more information on 401(k) loans, check out our show notes or our website, Fidelity.com/MoneyUnscripted. Be sure to like, follow, subscribe to the podcast to know when new episodes drop. We'll see you next time on Money Unscripted. It's your life. Get your money's worth.
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