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
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.