Borrowing From 401k – What You Need To Know

There are a ton of mixed opinions on whether or not you borrowing from 401k is a good idea or not.  The common retirement account has several properties that you need to think about before you borrow from it.  In this article I’ll go over everything you need to know, in a way that hopefully will allow you to relate it to your own situation and decide if it might be useful for you

First of all, if you’re in a tight spot you may be forced to borrow from your 401k.  Don’t be embarrassed or panic about it, 20% of people have actually done it [Employee Benefit Research Institute (2008)].  At the same time this doesn’t mean it is a good thing either, and later on we’ll look at some ways you can prevent the need of borrowing from your 401k account in the future.

Borrowing from 401k Basics

The first question usually asked is regarding how much can be borrowed.  You can borrow up to $50,000 or half of your 401k account balance, whichever one is lower.

When you take out a loan from your 401k, you usually need to agree to pay it back starting from your next paycheck, and maybe even more importantly is that in most cases you are not allowed to contribute anything more to your 401k until the loan is fully paid back.

The maximum loan time in most cases is 5 years, although there is nothing stopping you from paying it back earlier, and the earlier you can pay it back the better off you will be.  Now there is one special case, which is when you use the loan to help finance a real estate purchase, in this case you will have special terms that can allow you to pay the loan back over a longer period.

Borrowing from 401k Advantages

borrowing from 401k

The biggest benefit of getting a loan from your 401k is that even though you have to pay interest on the loan, you’re paying it to yourself.  To add on top of that, since you are loaning yourself money, you don’t need to pass a credit check.  So if you have a poor credit score and can only get really high interest loans, paying effectively no interest can be a huge benefit.

Another advantage is that unlike some loans, there aren’t any significant fees involved either.  At most there will be a small administration fee, but rarely anything more.

Next, as mentioned before, the loan has some flexibility, and can be paid back anytime within five years.  While I’m hopeful you can pay it back before then, it can be a useful cushion sometimes.

Borrowing from 401k Disadvantages

Before you get too excited on borrowing from your 401k, there are a few really important disadvantages you should know about.

There are 2 huge disadvantages that come with 401k borrowing.  Firstly, that money you just took out of your 401k, it’s not growing any more.  If you set-up your 401k trying to hit a certain target by your retirement, even a small loan for a month or two can set you back significantly.  If you take out a large loan, we’re talking about years of extra work being added on.

Secondly, while your payments and interest are being paid back to yourself, it’s also being taxed again when you’re getting your pay check.  What this means is that the money is essentially being taxed each time before it goes into your 401k, so in this case it is being double-taxed in the sense that when you eventually withdraw from your 401k you will be taxed again.  Consider getting an external loan instead, well you’ll still have to pay back the loan with after tax income, which is equivalent to paying back your 401k loan.  The reason that this can be a big deal is that a 401k loan can have a different interest rate than an external rate, and if you are paying more interest on your 401k loan you will be paying extra money that has been taxed.

Another negative of a loan as we discussed earlier is that in most cases you can’t make any contributions until you pay back your full loan.  So not only do you have less money in your account growing, you can’t add any to it either.

Finally, there is a specific situation I want to mention.  If you happen to have a loan active and get fired, you must pay back the full loan within 60 days.  If you are unable to do this, the loan is considered an unqualified distribution and you will pay penalties and fines.  So just make sure to consider your job security before taking any loan.

How to Avoid Taking a Loan

By this point you probably understand the 401k loan pretty well and can decide if it definitely does or does not make sense, but some of you may still be in a situation where you need the money for whatever has come up.  In this final section I’ll be covering ways to prevent needing to get a loan, or alternatives of getting a loan if you need the money.

Home Equity Credit Line (HELOC)

Since 2008 HELOCs have been not a great option typically, and there are a slew of other things you’ll need to know first, but it is another type of loan you could get, and it could potentially be better for you.  You’ll have to run the numbers using online calculators, but an alternative may be to get a home equity credit line.

Borrow from Family/Friends

Have you exhausted your options yet?  It can be hard asking for help sometimes, but if you are having a really tough time friends and family may be able to help you.  You can still offer to pay some interest on the loan, but at the same time you won’t be hurting your retirement fund.

Roth IRA Withdrawals

Roth IRA withdrawal rules allow you to withdraw any contributions you have made tax and penalty free.  If you have a Roth IRA you can think about using it instead; if you don’t have a Roth IRA think about starting one.

Make an Emergency Fund

One concept of personal finance that I just cannot stress enough is to have an emergency fund.  Depending on who you ask you’ll get different answers on the size you need, but if you have at least 2-3 months of expenses saved up you can usually cover any emergencies that arise.

2 Responses to “Borrowing From 401k – What You Need To Know”

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  1. Mark Deaton says:

    I have a question regarding a couple of your “Disadvantages” to borrowing from your 401K.

    1) You say your money is not “growing” any longer when you borrow. What’s the difference in me transferring $20,000 to a different fixed fund as one of my options -vs- borrowing $20,000 from my savings at a fixed rate? If the interest rate for the fixed fund is the same rate I borrow at, doesn’t the $20,000 block of funds end up at the same amout over the term of the loan?

    2) You say I’m being “double-taxed” on my contributions as I pay back my loan. I don’t think that’s true either. I’m taxed on my taxable earnings. Whether I’m making my loan payment to myself or the loan payment to my bank, the money I’m using for that payment is taxable earnings, so I don’t see it as being “double-taxed” but maybe I’m not looking at it properly.

    I have long tried to evaluate the borrowing from 401k good or bad issue. Many years ago I put it to a spreadsheet and I remember it being a disadvantage to borrow, but I can’t logically see why now. My company does not prevent me from continuing contributions if I take out a loan. So to me borrowing is literally being my own bank and the loan is like transferring some of my funds to a “fixed” fund. I understand the risk of being required to repay the loan in 60 days if I left the company but beyond that I don’t see the disadvantages. I only wish my company charged a higher interest rate for the loans. Although the loans seem to be out-performing the mutual funds, I’d like to pay myself higher interest…

    Thanks in advance for a reply!

    Mark Deaton

    • Dale Cahill says:

      Hi Mark, thanks for commenting!

      To try and answer your questions,

      1) When I say the money isn’t growing any longer I am referring to the money you have taken out as a loan. This is going to be one of the primary factors that affect whether or not a 401k loan will be good for you.

      The real cost with the loans is the missed growth (since you pay yourself the interest payments), so in general, if the expected growth of the money if it was left in your 401k is more than the interest you would pay if you got a loan from somewhere else, you would be better off getting a loan from somewhere else.

      Does that answer your question? I wasn’t 100% sure what you were getting at there.

      2) I see your point about the “double-taxation” being confusing, I’ll make sure to come back shortly and revise this portion of the article.

      However as far as your view goes you are absolutely correct. You will pay back the loan with after-tax dollars just like any other loan. I referred to double-taxing in regards to the fact that when you eventually withdraw from your 401k you will be taxed again. This is more an added cost to any loan that should be considered, thanks for pointing it out though. I’d like to add one more thing to this however, you mention you want to pay yourself a higher interest, but when you pay back the principle or the interest, remember that these payments are made with after-tax dollars, so ideally you would want a lower interest rate. (You can always contribute more money to your 401k if you are under the limit)

      So to sum it all up, you need to figure out primarily the expected growth (percentage) that you will miss out on if you borrow from your 401k and compare that to a loan you could get. So if your 401k typically gains at ~8%, and you can get a loan at 6% from a bank, it would make sense to keep your money in the 401k as you have a 2% (8-6) advantage. At the same time remember the interest of your potential 401k loan will have a small effect (refer back to above) and there are a few other potential disadvantages (payback time, and other things in the article that may or may not be an issue for you) that may sway your decision.

      I hope this clears up your issues a little bit at least, but let me know if you have any more questions!

      Dale

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