It can be tempting to borrow from your 401(k). Especially if you have a long time before retirement and you need some extra cash to cover an unexpected expense, pay off high-interest debt, or fund a major purchase. A 401(k) loan is a type of personal loan that allows you to access your retirement savings without paying taxes or penalties. However, before you decide to take out a 401(k) loan, you should be aware of how it works and make sure you have a plan to pay it back. Here are some important things to consider:
Pros of 401(k) Loans
Some of the advantages of borrowing from your 401(k) plan are:
They are easy, fast, and don’t require credit history. You don't have to go through a lengthy application process, provide a lot of documentation, or wait for a credit check. You can usually get the money within a few days of requesting it from your plan administrator.
Low interest rate. The interest rate on a 401(k) loan is typically lower than the rate on other types of personal loans, such as credit cards or signature loans. The interest rate is usually based on the prime rate plus one or two percentage points3. (Make sure to check your plan for your specific rate)
No tax or penalty. As long as you repay the loan on time and follow the rules, you won't have to pay any income tax or an early withdrawal penalty on the amount you borrow. This is different from taking a non-hardship withdrawal from your 401(k), which may be subject to both taxes and penalties.
You pay yourself back. The interest you pay on a 401(k) loan goes back into your own account, not to a lender. This means you are essentially paying yourself for the use of your money.
Cons of 401(k) Loans
Some of the disadvantages of borrowing from your 401(k) plan are:
Reduced retirement savings. When you take out a 401(k) loan, you are reducing the amount of money that is invested in your account and earning compound interest. This can have a significant impact on your long-term retirement goals, especially if you borrow a large amount, take a long time to repay it, or take out multiple loans.
Repayment risk. You are required to repay the loan within five years, or sooner if you leave your job. If you fail to do so, the loan will be treated as a taxable distribution, and you may have to pay income tax and an early withdrawal penalty on the outstanding balance.
Limited borrowing amount. Each plan has specific borrowing rules. A typical limit is up to 50% of your vested balance or $50,000, whichever is less.
Loss of protection. Your 401(k) plan is protected from creditors in case you file for bankruptcy or face a lawsuit. However, once you take out a loan, the money is no longer in your account and loses this protection.
Keep your future in mind
A 401(k) loan can be a convenient and affordable way to access some extra cash, but it also comes with some serious drawbacks. You should carefully weigh the pros and cons and consider other alternatives before you decide to borrow from your retirement plan. Remember, your 401(k) is meant to provide you with income and security when you retire, not to fund your current lifestyle. If you find yourself needing more cash, it may be a good time to review your budget, savings and investment amounts and allocate more money to non-retirement savings until you have a cash reserve built up.
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Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.
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