For many Americans, a 401(k) loan seems like the perfect way to access money. In this scenario, you borrow from your own account and repay yourself with interest. It sounds simple and like the right solution if you need quick cash because of a financial emergency. After all, it’s your money, and the principal and interest you pay go back into your account. But as with most financial dilemmas, it’s not as easy — or as great — as it sounds.
In fact, for most people, borrowing from a 401(k) is not the best solution. Yet, each year, about 11 million workers turn to their 401(k) plan to fund things like major financial emergencies, vacations or high-interest debt. While not all plans allow loans, many do, and the larger the company is, the more likely it’s allowed.
Let’s explore the rules of borrowing from your 401(k) and why you may want to think twice before you consider doing so in the future.
While rules can vary by employer, typically, the minimum amount you can borrow is $1,000 and the maximum is up to 50% of your vested account balance up to $50,000, whichever is less. Repayment periods are set at a maximum of five years unless you are borrowing for the purchase of a principal residence, which may allow a longer payback. Repayments are made by way of payroll deduction.
Like any loan though, there are a few pros and cons:
Obtaining a loan usually is a very simple process. Most times you can arrange for a loan over the internet or telephone.
Any interest you pay on the loan goes back into your 401(k) account. Typically, interest rates for 401(k) loans are set at the current prime rate, plus 1% or 2%.
You are borrowing against your financially secure retirement. The money you borrow — or take — out of your 401(k) account is not available to take advantage of any investment gains, so you are potentially sacrificing significant investment returns.
Loan repayments are not tax-sheltered dollars anymore since all repayments are made with after-tax payments. Once you retire and begin taking withdrawals, you will pay taxes yet again.
The loan is not tax deductible. It’s considered a consumer loan; therefore, no tax advantage.
Unless you completely repay the loan, it is considered a premature distribution from the plan. You would owe federal and state income taxes as well as a 10% early withdrawal penalty if you are under age 59½.
There also are consequences if you change jobs, quit or get fired by your current employer. In this instance, you’ll have to repay your outstanding balance within five years. Under the new tax law, 401(k) borrowers have until the due date of the federal income tax return.
While borrowing from yourself through your 401(k) may be a simple option, it’s likely not the only option.
As an alternative to a 401(k) loan, it’s often better for most people to take out a home-equity loan or another line of credit, as you may be able to deduct the interest on your taxes. Accessing your 401(k) account prior to retirement affects your psychology of saving. If possible, your retirement money should sit untouched until you retire. It’s too easy to get in the habit of dipping into your 401(k) account instead of saving for things you need along the way. To keep it in perspective, there are no lending institutions that will loan you money to retire.
The bottom line
For most people, borrowing from a 401(k) is not the best solution, even though it is generally thought of as a better option than taking an in-service distribution or instituting a hardship withdrawal from your 401(k). In general, it’s better for most to consider a home-equity loan or another line of credit, as you may be able to deduct the interest on your taxes. If taking money from your retirement is your only option, then a 401(k) loan may be right as a last resort.
Lorey Matties is a participant services specialist for Greenleaf Trust. She conducts retirement plan group meetings, meets with plan participants, develops the educational and informational materials and oversees the fulfillment of the quarterly participant statements. She has over 20 years of experience in the retirement plan field and is a Central Michigan University graduate.