With banks tightening their lending criteria and many people still struggling financially, some consumers are considering 401(k) loans to help pay down debt or cover a down payment. Unlike an early withdrawal from a 401(k), this type of loan does not require you to demonstrate a hardship such as paying for a funeral or preventing foreclosure. Nor is the money borrowed from your retirement account automatically subject to tax and an early withdrawal penalty, assuming you don't leave your job.
It may sound like an appealing option since you're paying interest to yourself rather than a bank, but 401(k) loans do come with risks and restrictions. Generally, you cannot borrow more than $50,000 or 50 percent of your vested account balance. (Your vested account balance includes all the money you've contributed, but sometimes employer contributions are subject to a vesting schedule.)
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As Bill Losey, president of Bill Losey Retirement Solutions and author of Retire in a Weekend, points out, "People don't realize they're paying the money back with after-tax dollars, and ultimately those dollars will be taxed [again] when they take out a 401(k) distribution." If you lose your job or leave before you've finished repaying the loan, you could pay even more in penalties. Also note that unlike a mortgage, you cannot deduct the interest on a 401(k) loan.
Here are four important questions to ask before taking out a 401(k) loan:
1. Does my retirement plan even allow it? Depending on how your employer's retirement plan is structured, borrowing from your account may or may not be an option. "When [companies] set up their 401(k) plan, they have the ability to customize it," explains Laura Adams, host of the Money Girl podcast and author of the book by the same name. "Many smaller companies will not include a loan option because it's an administrative headache, but many larger companies do offer loans." To find out if your employer offers loans, ask your benefits administrator or check your summary plan description, which should be sent to you annually. The process is similar for those who work at a nonprofit and have a 403(b) instead of a 401(k).
2. Do I feel secure in my job? If you're under age 59 1/2 and you get laid off or decide to leave your job before you've repaid the loan, you'll need to pay it back quickly—generally within 60 or 90 days. Otherwise, the outstanding balance could be reclassified as an early withdrawal and you could get hit with income taxes on that money, plus a 10 percent early withdrawal penalty. In that situation, taxes and penalties could eat up 30 percent or more of the money you can't pay back, according to Adams. That's why Adams and Losey encourage potential borrowers to do their best to ensure steady employment and avoid job changes during the five- to seven-year period when 401(k) loans are typically repaid.
3. Do I have an emergency fund or other ways to secure a loan? Because of the high risks involved with a 401(k) loan, Losey says it should be considered as a last resort. Tap your savings or emergency fund and consider other loan options before borrowing from your retirement account. "The interest on a 401(k) loan is typically one or two points above the prime rate," he says, adding that borrowing from a credit union or using a zero-percent credit card offer as a short-term loan could be cheaper and less risky. Although borrowing from relatives can be awkward, that option removes the potential for early withdrawal penalties and offers your relative a higher interest rate than they'd get from a bank. "If I said, 'I'll pay you back at 3 to 5 percent interest,' they're only getting 1 to 2 percent from a bank, so that might be a good option for both of you," says Losey.
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4. Am I willing to absorb the opportunity costs? Taking money out of your retirement account means you'll miss out on the opportunity for that money to grow. "You're suffering a loss of earnings whenever you take money out of an investment account," says Adams. "When you look at the long-term consequence of taking that money out, it can be a bigger dent in your retirement savings than you would think." Plus, Adams adds, "If you're not contributing to your 401(k), you're not getting matching funds from your employer." Use a 401(k) loan calculator to get a ballpark figure on how much borrowing from your 401(k) could impact your retirement account.