Borrowing From your 401(K)

Borrowing money from a 401(k) may be a helpful option for cash strapped workers...but it should be a last resort.

Many employers allow their employees to borrow money from their 401(k) plans. Just because you can obtain a loan from your plan doesn't mean it is always the best idea. So before sticking your hand in the cookie jar, you should consider the "pros and cons," some of which may surprise you.  Here are some facts to know about a 401(k) loan:

Borrowing Limits.  In general, you can borrow the lesser of $50,000 or one-half of your retirement plan balance. To accept the loan, you must typically agree to begin paying back the loan during your next pay period. Most often, this is done via an automatic deduction from your paycheck.

Lost Investment Growth.  Your borrowed 401(k) money will not be invested for your retirement for the entire time the money is outstanding from your 401(k) plan. Therefore, you forgo all potential investment gains from all borrowed funds for the duration of your 401(k) loan.

Negative Tax Impact.  When you pay back your loan, you do so with post-tax (after-tax) dollars. Consequently, a $100 loan repayment reduces your take-home pay by $100. Worse, when you take the money out of your 401(k) plan during retirement, you will pay tax on the same money again.

Risk of Termination.  No matter the cause, if you cease working with your current employer, your entire loan is usually due within 60 days. If you are unable to pay back the loan balance during that quick time frame, the entire amount you are unable to pay is deemed a distribution, which is likely
to be subject to significant federal income tax, state income tax, and early distribution penalties.

There are certain situations where it may not be prudent to borrow from your plan:

  1. You are planning to leave your job within the next couple of years.
  2. There is a chance you will lose your job due to a company restructuring.
  3. You are nearing retirement.
  4. You can obtain the funds from other sources.
  5. You can't continue to make regular contributions to your plan.
  6. You can't pay off the loan right away if you are laid off or change jobs.
  7. You need the loan to meet everyday living expenses.
  8. You want the money to purchase some luxury item or pay for a vacation.

It is critical that you know the rules and understand the relative advantages and disadvantages of a 401(k) loan before you sign on the dotted line.  And remember, the purpose of a 401k plan is to fund your retirement, so don't shortchange your golden years by treating it as a checking account. 

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