Although many employers have programs that let employees to take out loans on their 401(k) plans, there are often a number of different rules governing the loan so it is important to be aware of what those rules are.
The first thing to remember is that it is, in fact, a loan and you’ll be required to pay back whatever you withdraw. Often, that payment will be deducted directly from your paycheck. There are also limits on how much can borrow, which is usually about half of what you have available in your 401(k) plan.
In most cases you will have less than 5 years to repay the loan, with one exception. If you are taking the loan in order to purchase a home, the repayment period can be longer than 5 years. To find out for sure, it is best to talk with your employer prior to signing for the loan.
There are pros and cons to borrowing from your 401(k). One of the advantages is that you will not have to go face a credit check, and for those with so-so credit, this is a big plus.
Another advantage to this type of loan is that even though you will have to pay interest on the loan, the interest rate will not be high, regardless of your credit. And unlike a regular loan, the interest you pay is ultimately going to be your money, so you are not throwing money away to a bank.
As for the downside, any money you withdraw from your 401(k) will be taxed as income. You will lose any gain you might have received while that money was being invested, ultimately reducing your overall return. You will also want to consider what will happen with the loan if you stop working for that employer. In most cases your loan will come due within 60 days after you stop working. If you cannot pay back the loan, the employer will count it as a distribution and you’ll likely have to pay an early withdrawal penalty.
So, is borrowing from your 401(k) the right thing to do? That depends upon you and your circumstances. If you must dip into your 401(k), it’s certainly better to do it as a loan rather than a distribution but unless you’re faced with an emergency, you may want to find another way to come up with the cash.
Mr. Kraft assists clients primarily in the areas of estate planning and administration, Medicaid planning, federal and state taxation, real estate and corporate law, bringing the added perspective of an accounting background to his work.