401(k) Loan Pros and Cons

What You Need to Know Before Considering a 401(k) Loan

401k loans
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One of the greatest benefits of a 401(k) is also a potential drawback: the 401(k) loan. Not all 401(k) plans let employees borrow a portion of their own savings, that’s up to the employer and plan administrator, but many do. If your plan offers a loan that you have considered taking, learn more about what’s good and bad about 401(k) loans.

401(k) Loan Advantages

The biggest advantage of a 401(k) loan is that you are both the borrower and the lender, so you pay yourself back with interest.

If you have to take a loan, it’s better than having to pay back anyone else. The interest you pay yourself is tax-deferred, meaning it comes directly from your pre-tax paycheck and you won’t pay taxes on it until the 401(k) is distributed after retirement.

You skip all of the loan application and processing fees that can add to your loan debt. And 401(k) loans are typically offered at a very competitive rate of interest. You do have to apply, but you will not likely be turned down. These loans have few if any restrictions and no credit check is required. (And a default on this type of loan does not have the same credit impact that it would on a traditional loan.)

401(k) Limits and Restrictions

Typically, individuals are allowed to borrow 50% of their 401(k) account balance up to a maximum $50,000. They may also have a minimum threshold of around $1000. Terms for 401(k) loans typically five years or less.

If you are using the money to buy a home, you may be given a longer payback period of up to 15 years. As the owner of the 401(k) account, you can decide which assets to liquidate to borrow from, so you may be able to borrow the money without having to touch your better-performing investments. Your plan administrator can give you a sense of limits and restrictions specific to your account.

401(k) Loan Disadvantages

There are two major biggest disadvantages to a 401(k) loan. The first is that you are utilizing money that would otherwise be working for you. It’s an opportunity cost, because you are missing out on potential growth. (To be fair, you could also miss out on a bad market, which may be a good thing.) Sure, you are earning interest as a lender, but it’s not a high rate of interest.

The second disadvantage is the potential for default. If you lose your job or leave your job, many plans will require that you pay back the loan within 60 days. After that, it will be considered a distribution on your 401(k). You will likely owe taxes on the money, plus (if you are younger than 59 ½) a 10% penalty fee.  Imagine a scenario in which you are laid off and suddenly made to choose between a hefty loan bill or a hefty tax bill. This could easily happen if you take a 401(k) loan. (There are some exemptions to 401k early withdrawal penalties.)

So Should You Take a 401(k) Loan?

The bottom line is you need a 401(k) to foster a secure retirement. Anything that puts that at risk should be considered carefully. If your only other choice is to pull the money out of your 401(k) entirely, than a loan is the better option.

However, if you have any other options, just leave the 401(k) alone.

The content on this site is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.