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.
Avoid 401k Debit Cards at all Costs
Many consumers are looking for easy access to additional funds since the financial crisis and recession. Even though the recession is technically over, many are still feeling the pinch. As a result, there has been a bigger move toward tapping retirement accounts as emergency funds.
One of the ways that it has been made easier to get a 401(k) loan is by adding a debit card to the account.
What is a 401(k) Debit Card?
Many 401k providers have begun allowing account holders to apply for a 401(k) debit card. Your 401(k) debit card can be used to access money that you already have in your account. However, even though it is called a debit card, it’s really more like a line of credit.
When you use the 401(k) debit card, you end up paying fees and interest and making payments to repay the loan. It’s true you are borrowing from yourself, but it can still result in lost opportunities. It reminds me more of the card I have to access my Preferred Line of Credit at the bank, or the card you can get to access a HELOC.
It’s also important to note that you can’t just access your entire nest egg with a 401(k) debit card. First of all, your employer’s plan has to offer the option of using a 40(k) debit card. Then you end up with a pre-approved amount that you can draw on. That money is moved to a money market account, and you withdraw from that account. Even though the money attached to your 401(k) debit card does earn a return in the money market account, it may not be as much as your other assets are earning in the main account.
With the 401(k) debit card, all of your charges are added up on a daily basis. The total of daily charges counts as a single loan. Then, each month, all of your charges (and interest and fees) are added up. Realize that there is no grace period with your 401(k) debit card; the interest starts accruing as soon as charges appear on your card. Additionally, you should realize that the use of your 401(k) debit card can come with an annual fee, as well as a setup fee. Plus, you are charged a small fee each time you use the card to obtain cash. There is no waived fee for using the bank the account is set up at.
Why 401(k) Debit Cards are a Horrible Idea
When you look at the averages related to retirement, it becomes fairly obvious that the last thing consumers need is easy access to their 401(k) accounts. Not only will it cost in you in fees and interest, but you also miss out on earnings that you could receive. When that money isn’t in your account, earning a return, you lose out. That time (and the compound interest you would have earned) can’t be replaced.
Not only that but being able to access your 401(k) so easily can lead to impulse spending. With your retirement account. It’s much easier to pull out the debit card and access your 401(k) funds with this process, and that can lead to impulse spending and serious problems with building your nest egg. Unfortunately, the very people that these debit cards are marketed toward are the very people that are the least likely to exercise restraint.
There have been a couple efforts to ban 401(k) debit cards, but they have, for the most part, amounted to nothing. The latest attempt has been referred to a committee and doesn’t look as though it will make it out. Indeed, GovTrack reports that this bill has a 1% chance of being enacted.
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.