What You Should Know About 401(k) Loans

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If you are in a pinch and need money quickly, the idea of a 401(k) loan can be appealing. Instead of paying double-digit interest to a credit card company, you can pay interest to yourself, effectively contributing more money to your retirement plan.

Here are five things that every new investor should know about 401(k) loans.

401(k) Loans Are Normally a Very Bad Idea

When considering whether or not to take a 401(k) loan, be aware of a few major catches. 

If you lose everything and need to declare bankruptcy, ordinarily, your retirement plan assets, such as a 401(k), 403(b), traditional IRA, Roth IRA, SEP-IRA, and simple IRA are protected. Think of these as safe havens, or lock boxes, that creditors have a very hard time touching. If you start raiding your 401(k) to try and save your home, that money is fair game to creditors once it is taken out of the account in the form of an outright withdrawal or loan. 

If you lose your job or change employers, your entire 401(k) loan balance is due within 60 days. If you can't repay it, the money is treated as a withdrawal. You will owe all federal and state income taxes on it, plus an additional 10 percent penalty tax if you are under the age of 59.5 years old. You'll be lucky to be left with 50 to 70 cents on the dollar, meaning you're going to get a huge tax bill at the very moment you find yourself without work.

Not All 401(k) Plans Allow You to Take a 401(k) Loan

While the law allows companies to offer 401(k) loans in their plans, they are not required to do so. In fact, some employers vehemently oppose the entire idea of 401(k) loans because management or owners believe that retirement assets in these accounts should be as sacrosanct as pension assets—held beyond reach and out of the way of temptation. Additionally, some employer plans only permit 401(k) loans for specific purposes, such as buying a home or paying medical expenses. 

During the Great Recession of 2008-2009, a number of people had lived beyond their means and unfortunately found themselves unable to make credit card debt payments or pay their mortgage.

Instead of being intelligent and declaring bankruptcy or going into foreclosure, they wanted to raid their 401(k) assets by either making an outright withdrawal, which would trigger regular income taxes plus a 10 percent penalty tax for those under the age of 59.5 years old, or taking a 401(k) loan. 

Not wanting to hand their money over to the IRS, most opted for the latter until they found out that their company plan didn't offer 401(k) loans for this very situation—to prevent people from mortgaging their future to pay for today.

The Maximum 401(k) Loan Is the Lesser of $50,000 or 50 Percent of Your Account Balance

Even if you have millions upon millions of dollars in your retirement account, the maximum 401(k) loan you can take is the lesser of 50 percent of your account balance or $50,000. There are no exceptions. If your family has a very high income, that isn't going to do you much good. 

Your Plan Sponsor Controls the Interest Rate Charged on Your 401(k) Loan

When repaying money borrowed from your retirement plan, you must pay interest. True, the interest is paid to yourself, meaning it is more of a transfer from one pocket to another than it is a real expense, but you still have to come up with the cash. Unfortunately, you don't control the interest rate—the plan sponsor does. 

The Law Establishes the Repayment Period for Any 401(k) Loans

When you borrow from your 401(k) account, you have to repay the money, with interest, over 60 months. That five-year period can be extended for those who use the borrowed money to purchase a primary residence, though in most cases, a 401(k) loan isn't going to be nearly as attractive as a traditional mortgage loan from a local bank. 

All in All, Just Say No to 401(k) Loans

While the 401(k) plan can be a great way to save for retirement, building wealth through years of tax-advantaged compounding, removing money from the account early can be a huge mistake, even if you intend to repay the funds.