Borrowing from Your 401(k): What to Know Before Making the Decision
By Cindy Sandomenico
Borrowing money from your 401(k) account can be tempting. You know the money is there, and it’s yours, so why not use it?
Before you pull the trigger, however, consider the limitations and consequences. Here are some important points to keep in mind.
Know the rules
- Generally, you can borrow from a 401(k) for any reason, such as paying educational expenses or buying a home for the first time — although employers are not required to offer a loan option within the 401(k) plan. You can borrow no more than 50 percent of your vested balance at the time the loan is issued, up to a maximum of $50,000.
- Most plans require you to pay the money back within five years, unless you use it to buy your primary home. In that instance, employers may extend the loan repayment time for up to 15 years or 20 years, or more.
- Most plans limit you to one outstanding loan at a time, so you can’t borrow again until the first loan is repaid.
- Most plans charge a reasonable rate of interest at the time the loan is taken out – for example, the prime interest rate plus 1 percentage point. This can be less expensive than running up a credit card balance or using a line of credit.
- A loan can keep you from simply withdrawing funds outright from your retirement savings in the event of a financial crisis.
- It’s simple and fast. There’s less paperwork and fewer restrictions compared to other loans, and you can usually get a 401(k) loan in days.
- As with any loan, a 401(k) loan can be a blessing or a curse, depending on your circumstances. Using the money, if your plan allows it, for vacations or fancy home upgrades, is a red flag. You should never use a loan to live beyond your means.
- Taking out a 401(k) loan creates a bigger dent in your retirement savings than you may realize. While most plans allow you to continue to contribute to the plan and receive the employer match, many of those who take out loans reduce their contributions or stop contributing altogether to pay off the loan. That means you’re giving up free money and losing out on the appreciation gains it would have produced, and the amount you lose will likely exceed the amount you save by borrowing at a low interest rate.
- If you leave your job or are terminated, most plans require you to repay the loan in full within the next quarter. If you don’t, the money is treated as a distribution, which means it’s taxable as income, in addition to incurring a 10 percent early withdrawal penalty. However, some plans allow you to keep the loan and make payments to a third-party administrator. If you’re considering leaving your job, or you think you could be laid off or fired, taking a loan is not a good idea.
If you’re considering a 401(k) loan, talk to human resources to make sure you have all the information about your company’s plan before moving forward. Doing so may save you a lot of heartache later on.
If you would like to learn more, here is another blog about borrowing from your 401(k) account.
Cindy Sandomenico is a Manager and member of the firm’s Employee Benefit Plan Leadership Team, which oversees the Employee Benefit Plan Group at Wiss & Company, LLP. If you would like to speak with Cindy, you may reach her at email@example.com or at 973.994.9400.