Among the many benefits afforded to many 401k participants is the ability to borrow funds from the account for personal purposes. While 401k loans are not generally recommended, they can be a source of low cost borrowing that can help improve your financial situation if used responsibly. If your plan includes a loan provision, you should carefully review the rules and requirements as they can differ from one plan to another. Also, you should weight the advantages and disadvantages of borrowing from your 401(k) to determine if it’s the right course of action for your circumstances.
401(k) Borrowing Overview
Loan Provision: Most plans allow for loans up to one-half of your account balance, or $50,000, whichever is less. Repayment must begin with your next paycheck from which payments are automatically deducted.
Loans used for any purpose other than buying a house must be repaid within five years. A home purchase loan can be extended further, however, if you leave your employer, it must be repaid within 60 days of termination or else it will be treated as a taxable distribution.
Key Advantages of Borrowing From Your 401(k)
- No impact on credit: Since you are, in essence, loaning your money to yourself, a 401(k) loan does not become a part of your credit history, nor are there any credit checks required.
- Pay interest to yourself: If you have to pay interest on a loan, why not pay it too yourself. The loan rates are very reasonable, much lower than you would pay on credit cards or personal loans, and the interest is credited to your account, so you are still generating a return on your borrowed funds.
Key Disadvantages of Borrowing From You 401(k)
Lost investment returns: Your borrowed funds will no longer be earning investment returns which, over time, can be a significant opportunity cost. However, your loan payments will be added to your investment accounts based on your selected allocation.
- Loan repayment tax implications: You were able to make your original contribution to your 401(k) plan using before-tax dollars, however, loan payments are made using after-tax dollars. This doesn’t make your loan any more expensive than any other type of loan, it’s just that you have, essentially, lost one of your key tax benefits of using before-tax dollars. Additionally, you will pay taxes on your after-tax contributions when you eventually withdraw them.
- Risk of termination: Perhaps the biggest disadvantage, potentially, is the loan repayment rule that takes effect should your employment be terminated for any reason. The rule requires that the outstanding loan balance be repaid within 60 days, otherwise it will be treated as a taxable distribution. In addition to federal and state taxes owed, you may also be subject to a 10% early withdrawal penalty by the IRS if you are under the age of 59 ½.
Borrowing from your 401(k) should be a measure of last resort. The stakes of your secure retirement are extremely high, and you will need every opportunity to accumulate the funds you’ll need, especially where tax benefits are available. Still, if you absolutely have to tap into your 401(k), borrowing the funds would be much more advantageous than taking an outright distribution.