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Borrowing from Your 401(k): Pros and Cons

When no better options are available, you may consider borrowing from your 401(k) to cover short-term or unexpected financial needs.  Here are the pros and Cons to consider.

With changes in the retirement landscape, companies have shifted more of the burden of saving and investing for retirement to individuals. For many Americans, 401(k) plans have become the primary means of saving and growing assets to fund the retirement they envision. Ideally, you are taking full advantage of your 401(k) plan by contributing early and regularly and keeping these assets invested.

However, in some cases when no better options are available, you may consider accessing your 401(k) to cover short-term or unexpected financial needs.

How a 401(k) Loan Works

When you borrow from your 401(k), you are effectively borrowing from yourself, rather than from a bank or other third-party lender. The amount of the loan is deducted from your 401(k) plan balance. You agree to pay back the amount plus interest in regular payments over a specified period of time, usually no more than five years. As you pay back principal and interest—typically as an automatic deduction from your payroll—these payments are reinvested into your 401(k) plan.

Keep in mind that many plans charge an upfront fee at the time of the loan and/or a yearly service fee. 401(k) plans also place specific limitations on the amount that can be borrowed from the plan, including a minimum account balance, minimum loan amount and maximum loan amount.

Potential Advantages of a 401(k) Loan

Convenience. In most cases, getting a loan from your 401(k) is convenient and fast, with no credit check or long credit application.

Low rates. The interest rate you pay on the loan is relatively low, generally one or two percentage points above the prime rate. In addition, the interest payments you make are paid back into your plan, rather than to a bank or credit card company.

Flexibility. In most cases, you can select which investments you would like to liquidate in order to fund the loan.

Longer repayment period for home loans. Most plans allow longer repayment periods for loans used to cover mortgage expenses.

Early repayment. You can usually choose to pay back the loan early without penalty.

Potential Downsides of a 401(k) Loan

Opportunity cost. When you take a loan from your 401(k), you will need to liquidate some investments. This means that you will lose any investment return on the amount borrowed. While the interest you pay on the loan is intended to help make up for this lost return, the interest rate paid may be less than the rate the investments would have otherwise earned.

Required repayment if you leave your job. Most plans require loans to be paid back in full within 60–90 days of leaving employment. If your job is terminated or you change jobs unexpectedly, this can easily result in a loan default. If you default on the loan for any reason, the outstanding balance will be considered a distribution and will be taxed as ordinary income and may be subject to the 10% early withdrawal penalty if you are under age 59½.

Tax treatment. The interest you pay on a 401(k) loan is generally not tax deductible, unless the funds are attributable to employer contributions or are secured by a home mortgage.

Although borrowing from your 401(k) can provide a ready and convenient source of funds, the decision to take a loan from your 401(k) is one that should be considered carefully as it could impact your retirement goals. If you’re considering a 401(k), talking to an experienced Financial Advisor can help you understand what your options are, as well as how taking a 401(k) loan might affect your long-term financial objectives.

 

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