Why Millennials are Borrowing from their 401(k) Plans – and Why it’s a Bad Idea

Published on October 4, 2016

It’s tempting to use those funds in a 401(k) plan to put a down payment on a home or to consider it as your children’s college account. It seems that a number of millennial workers are inclined to do this, according to an article in Investment News.

The author cites a Scarborough Capital Management survey that found that 12 percent of people ages 18 to 34 with 401(k) accounts have pulled money out of them to buy their first home. Of the slightly older millennials and younger Gen Xers (ages 35 to 44), nearly eight percent have done so. Older adults “borrow” from these plans at a lower percentage.

Another reason cited by millennials for using retirement funds: paying for their children’s college. In fact, almost half of the survey respondents said they were considering using 401(k) assets to pay for this expense. The 35-44 year-old-group was at 26 percent.

It seems younger savers might not understand all the ramifications of doing this, such as the fact that the borrowed funds tend not to be replenished or paid back; therefore, account holders lose the potential investment gains their funds could earn over time. Plus, there are limits to how much you can borrow and rules about paying it back, so if taking a loan from a 401(k) is calling your name, you are best served to call your trusted adviser to discuss this first.

Rather than resort to this tactic, which could cost a lot of money over time (in terms of those taxes, penalties, and lost investment returns), why not borrow funds from someone you know who has a self-directed retirement account?

Unsecured loans are one of the many nontraditional investments that self-directed investors can make. These include loans for tuition. The account holder and borrower set up all the terms of the loan, from interest rate to time period; then, the account holder sends the instructions regarding disbursement of funds to the self-directed retirement plan administrator along with the note that was created, who executes the transaction (among other important administrative responsibilities).

As with any self-directed retirement transaction, all income and expenses related to the asset—in this case, the loan—must flow through the IRA. This is not a personal loan between two people; it is a loan between a self-directed IRA and an individual. The retirement account earns interest on the loan, the friend or colleague is able to make the purchase or payment he/she desires, and everyone wins.

In order to protect the self-directed retirement plan’s tax-advantaged status, it’s important that the account holder not make a prohibited transaction to a disqualified person, so always check with your plan administrator before making these arrangements.

If your account is held at Next Generation Trust Services, be sure to contact our helpful professionals for insights into this type of transaction, at Info@NextGenerationTrust.com or 888.857.8058. We will also conduct a comprehensive transaction review to ensure you are conducting a transaction that complies with IRS guidelines.