Via a 401(k) loan, many employers allow their employees to borrow money from their 401(k) plans. Make sure you know the rules and understand the relative advantages and disadvantages of a 401(k) loan before you sign on the dotted line. Here are nine things to know about a 401(k) loan:
401(k) Loan Fact 1 - Borrowing Limits
In general, you can borrow the lesser of $50,000 or one-half of your retirement plan balance. To accept the loan, you must typically agree to begin paying back the loan during your next pay period. Most often, this is done via an automatic deduction from your paycheck.
401(k) Loan Fact 2 - Loan Length Restrictions
Unless you use the money to acquire a home, you must pay the loan back over five years or less. If you borrow the money so you can purchase a residence, the length of the loan may be significantly longer, but be sure to note the risk of termination below.
There are several advantages and disadvantages of 401(k) loans. First, the advantages:
401(k) Loan Fact 3 - No Credit Check Required
No credit check will be performed if you request a 401(k) loan since you aren’t actually borrowing money. Instead, you are temporarily tapping your retirement funds. Since no entity is loaning you money, there is no need to check your credit.
401(k) Loan Fact 4 - Pay a Competitive Interest Rate . . . To Yourself
Regardless of your credit score, you’ll pay a competitive interest rate. The rate is often in the neighborhood of prime, consistent with typical consumer loans. Better yet, you’ll pay the loan, including the interest, to yourself - not to a bank. The entire amount of each loan repayment goes to your 401(k) account.
401(k) Loan Fact 5 - Low or No Application Fees
Since a 401(k) loan isn’t a true loan, any application fees are usually minimal.
Consider several important disadvantages before requesting a 401(k) loan:
401(k) Loan Fact 6 - Lost Investment Growth
Your borrowed 401(k) money will not be invested for your retirement for the entire time the money is outstanding from your 401(k) plan. Therefore, you forgo all potential investment gains from all borrowed funds for the duration of your 401(k) loan.
401(k) Loan Fact 7 - Negative Tax Impact
When you pay back your loan, you do so with post-tax (after-tax) dollars. Consequently, a $100 loan repayment reduces your take-home pay by $100. Worse, when you take the money out of your 401(k) plan during retirement, you will pay tax on the same money again.
401(k) Loan Fact 8 - Risk of Termination
No matter the cause, if you cease working with your current employer, your entire loan is usually due within 60 days. If you are unable to pay back the loan balance during that quick time frame, the entire amount you are unable to pay is deemed a distribution, which is likely to be subject to significant federal income tax, state income tax, and early distribution penalties.
401(k) Loan Fact 9 - Better Than a Distribution
While a 401(k) loan has some benefits, its significant negatives ought to be avoided except during a genuine financial emergency. Still, if your only other source of money in an emergency is an outright distribution of your 401(k) money, a 401(k) loan is the preferable option.