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Should You Borrow from Your 401(k)?


should-you-borrow-from-your-401k-body.jpgSometimes, when you need money, you don't always have a lot of great options, especially when you want to avoid paying an arm and a leg in interest. One option to quickly gather funds may be to take a loan from your 401(k) account. Let's be clear that this should not even be a consideration for those times you simply want some expensive new electronic or other unnecessary purchase. However, sometimes we have real needs for cash that may justify taking a hit to our retirement savings:

  • Major and unavoidable home repair

  • Down payment for first-time home purchase

  • College funds for ourselves or our children

  • Large medical expenses

Let's go over the details of borrowing from your 401(k) should you ever find yourself in a situation like those we listed.

Borrowing from your 401(k)

Your employer, who is in charge of your 401(k), generally creates the rules on loans, including whether loans are available. Most plans do allow loans, but your first order of business is to verify you're able to take a loan from your account. If your plan offers loans, here are borrowing guidelines:

  • If you haven't taken any other loans from your account in the last year, usually you'll be allowed to borrow up to 50% of your vested account balance or $50,000, whichever is less. Your vested account balance is the amount of the account that you already own, not including any employer contributions that would be taken back if you left the company.

  • If you have taken another loan from your account in the last year, that amount counts toward the 50% vested account balance or $50,000 limit, decreasing your available loan funds for this round, if available.

  • You cannot borrow from a former employer's 401(k) account if you are no longer an employee of that company and active member of that 401(k) plan. However, you can roll an old 401(k) balance to your current plan and take a loan from your new total balance.

  • Since you're borrowing from yourself, you make the choice on which investments you withdraw the funds from. To minimize loss of investment opportunity, it's smart to discuss your funds with your investment advisor.

  • Though interest rates are plan dependent, usually 401(k) loans are charged at the prime interest rate plus 1%.

  • Some plans require you to move money out of your investment funds and into a money market type account to help offset interest charged.

Repaying your loan

The real key to minimizing negative consequences of borrowing from your 401(k) is repaying the borrowed amount on time or early. Usually there is no prepayment penalty, so make it your goal to pay your loan back as soon as possible.

  • In most cases, you must repay your loan within five years. Most repayments are collected by payroll deduction.

  • If you follow your repayment schedule properly, you will not be subject to income tax or a 10% penalty on the funds you withdrew.

  • In some plans, if you fail to repay your loan on schedule or if your employment is terminated before you pay back the loan, unpaid amounts are distributed as income, which is subject to tax and a 10% withdrawal penalty.

  • Depending on the rules of your plan, you may be prevented from making plan contributions while you repay a loan, especially for hardship withdrawals. If that is the case for your plan, you must consider whether your need for the loan outweighs the loss of investment opportunity.

Related reading: Is Your Retirement Savings on Track?

Consequences of borrowing from your 401(k)

When you borrow from your 401(k), it's likely to cost you less in interest than running up a credit card balance or taking out another, higher interest sort of loan. However, there are potential negative consequences to consider:

  • 401(k) loans are not tax deductible like other consumer loans.

  • The biggest cost to taking a loan from your 401(k) is likely to be missed investment opportunity. Aside from the possibility of not being able to invest while repaying your loan, the money you withdraw will not be invested and able to grow during the loan term. Depending on the time period involved and how the market performs, this loss of investment opportunity could significantly and negatively affect your account's future.

As with any financial decision, the decision to borrow from your 401(k) must be based on whether a 401(k) loan offers the fewest negative consequences to your future self when compared to other loan options. For more help accumulating savings, check out our ebook.

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Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.

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