Unless you're a creditworthy sovereign nation, you've probably gone through life assuming that your can't borrow money from yourself. Well, thanks to the arcane rules surrounding 401(k) retirement accounts, you actually can—well, sort of. We keep these accounts cordoned off from the rest of our finances because they're tax-free until we cash them out, but just because you haven't paid taxes on it doesn't mean that it isn't your money. If need be—and most do not recommend it—you can borrow from your retirement savings and pay it back, with interest.
Generally speaking (the specific terms are set by your plan's sponsor), you can take out a loan of up to 50 percent of the balance of your retirement account, so long as it doesn't exceed $50,000, and typically these loans are paid back over a period of five years with automatic payroll deductions.
Like we said, however, this isn't considered a wise decision by most financial planners because there are lots of potential downsides. Here are a few things to consider before taking the plunge:
1. Your Job Security
This might be the most important thing to consider, given the special nature of your 401(k). If you take money out of your 401(k) early, you have to pay income taxes on the money and additional penalty taxes if you do so before you’re 59 and a half years old. But if you take it out in the form of a loan and pay it back through payroll, you don't have to pay taxes on it immediately (though you do pay the loan back on after-tax income). But if you lose or leave your job, you usually need to pay back the loan very quickly (typically 60 days) and if you can't do that, then you have to pay the taxes and the penalties you would had you just taken the money out.
That's likely not something you're going to be in a position to do had you already resorted to borrowing from your 401(k), and then lost your job.
2. The Interest Rate
This is a loan product, and despite the fact that you're lending money to yourself, you still need to pay interest—to yourself. Yes, it would be nice to give yourself an interest-free loan out of your own tax-protected coffers, but that simply doesn’t happen. And anyway, this is a good thing for your retirement. Because you’ve taken your money out of the fund, it will be good to know its earning interest elsewhere, even if it comes out of your pocket.
That said, the interest rate on your 401(k) loan will be competitive when compared to even a low-interest credit card. Typically, your rate will be the prime rate plus one or two percentage points, and currently the prime rate is holding steady at 3.25 percent.
3. Your Credit
Your credit score won’t affect your ability to borrow from yourself directly, but it’s worth taking into account. If you have excellent credit, there are less-risky ways of accessing capital than by tapping into your oh-so-sacred retirement savings. A low-interest credit card will have a higher interest rate, but your monthly payments won’t skyrocket should you lose your job.
But if your credit stinks, a 401(k) loan might be a good idea by comparison. If you’re looking at paying 25 percent annually to borrow money, a 4.25 percent loan might look attractive, even if it does expose you to some serious risk.
4. Am I Really Doing This?
That really is the last consideration. Are you really going to go through with this? Tapping into half of your retirement savings to buy a car, or whatever? It’s certainly up for debate whether 401(k) loans are a terrible idea or not, but there are significant risks and you’d be a fool to jump at the opportunity just because the low rates are attractive.
Just be sure you’ve exhausted all other options before you go through with it. Even if it’s better to be in debt to yourself than to some faceless corporate giant, in a spiritual sense, it might not make practical sense in the long term. Talk to a financial advisor and know that you’re making the right choice.
Willy Staley is a staff writer and columnist for MyBankTracker.com. His columns cover banking technology, personal finance tools, government policy, and culture.