A 401k plan is designed to help you save money for your retirement years. Ideally, you contribute to the plan throughout your working years, and your contributions and earnings compound until you retire and begin taking distributions. In less ideal situations, people look to their 401k money in times of economic hardship or when they need a loan. While it is often possible to take a 401k loan, it may not be in your best interest to do so.
Here is how to take a loan from your 401k plan – and some information which may help you come to the conclusion that you really shouldn’t!
How to Take a Loan From a 401k Plan
How 401k Plan Loans Work. Most 401k plans allow individuals to take a loan up to 50% of the account balance, or $50,000 – whichever is less. For most loans, you’ll have up to five years to repay it, with the exception of borrowing from a 401k plan to buy your first home, which offers a longer repayment term.
Generally, there is no early withdrawal penalty imposed for borrowing money from your 401k, where as taking a hardship withdrawal is considered an early distribution and results in a 10% penalty (see general 401k distribution rules from the IRS). If you have to choose between a 401k loan and a hardship withdrawal, always go with the loan to avoid that penalty.
If you decide to take a loan from your 401k, simply contact your plan administrator for the process. Sometimes it only requires a phone call, other times you may need to fill out a short form to request the loan.
Benefits of a 401k Loan
You can take a loan from your 401k without having to go through a credit check, since you are simply spending your own money. There is no application process and you know you will be approved for a loan provided your 401k plan administrator allows loans.
Money borrowed from a 401k will be paid back with a low interest rate. The interest you pay is also paid to yourself, however, which means you’re just growing your own retirement with the interest payments.
Once you request a loan, you will often have the funds within a few days.
Disadvantages of a 401k Loan
Here’s the section which may change your mind about wanting to borrow from your retirement!
Lost opportunity. When you take money out of your 401k plan, you lose out on the opportunity for compound interest. The beauty of a retirement account like a 401k is that the money earns interest and both the contributions and interest are used to invest and compound to speed the growth of your money. When you take money out, you reduce the amount of interest and capital gains your portfolio earns, and the amount can be quite substantial over the years.
Taxes and penalties if you fail to repay the loan. If you fail to pay back the loan, it’s considered an early distribution of your retirement account if you are under the age of 59 and a half. This means the money withdrawn is subject to income taxes and a 10% penalty.
Loan repaid with non-tax sheltered money. Money used to repay your 401k loan is not tax-sheltered. The payments are made with after-tax dollars. Then, when you actually begin taking money from the retirement account upon retirement, you’re going to pay taxes on that money again as income.
Immediate repayment if you leave your employer. This is the kicker: The loan is due in full when you leave your employer, even through no fault of your own. This can cause serious problems if you are laid off or fired before you had a chance to repay your loan.
Alternatives to a 401k loan
There are several options, depending on how much money you need, how quickly you need it, your credit score, and your financial situation. If the 401k loan is for a car or home improvement, then consider applying for an auto loan or a HELOC. Another alternative is applying for a loan through a peer to peer lending company such as Lending Club. Lending Club and similar companies allow regular people such as you and me to legally lend and/or borrow money to other individuals. It’s a great opportunity for some people to borrow money outside of a banking environment, and it can be a great investment opportunity for lenders.