If you find that you need a loan to meet immediate needs, you may be tempted to borrow money from your 401k retirement plan. After all, it's your money, and who better to ask for a loan than yourself?
Still, you should think twice before tapping your 401k plan for a loan. You could be causing irreparable harm to your retirement when there may be alternatives, such as a line of credit, that could meet your financial needs more effectively.
The Pros of Borrowing from a 401k
To be sure, a 401k loan has its attractions, besides being easy to get. You're allowed by law to borrow up to $50,000 or 50% of your funds, whichever is less, and take five years to pay off the loan - more if the money is used to buy a house.
Interest rates are competitive; you're usually charged prime plus one or two percentage points. Since you're also the lender, the interest you pay is also the interest you earn. Indeed, you might find that lending some money to yourself is a good way to diversify your investments.
The Cons of Borrowing from a 401k
Nevertheless, there are many good reasons not to tap into your retirement assets. The money you withdraw is no longer in its tax-protected shelter doing what it's supposed to be doing. Instead of the 401k funds being invested in a tax-deferred account until you liquidate them upon retirement, the money you earn as the lender is taxable.
The taxes cut into your return, too. Over the long run, you're likely to make less money by lending money to yourself than you would have made had you left the money invested in a diversified stock and bond portfolio in your 401k account.
If you borrow money from your 401k and then lose or quit your job, you're likely to have to pay back the entire loan within 60 days. If you can't pay back the loan on time, you'll have to pay a 10% penalty on the balance of the funds if you are under 59½, and you'll have to pay income taxes on the money - that would be a withdrawal, not a loan.
Keep in mind, too, that some companies don't allow you to contribute to your plan while a loan is outstanding. Most employers are also likely to deduct your payments from your paycheck. That may be convenient, but it doesn't allow you the flexibility you might have with another type of loan.
Alternatives to a 401k Loan
There may be times when there are no alternatives. You may have a financial emergency and have no other choice but to withdraw funds from your 401k account or take a loan from it. In that case, borrowing is the much better choice.
On the other hand, if you own a home and have untapped equity in it, a line of credit is hard to beat. Home equity loan rates are generally considerably lower than the rates on a 401k loan, and a line of credit is an ongoing account that you can easily tap into as your financial needs arise.
Although 401k loans are easy to obtain, they may have tough consequences. Weigh the pros and cons of such a loan carefully before you decide what's right for you.