Understand the implications of a 401(k) loan to decide if it's the right option. By Rachel Hartman
IF YOU NEED EXTRA FUNDS for a large purchase or you're in a tight money situation, you may have the option to borrow money from your 401(k) plan. Some companies allow you to take a loan from your 401(k) and then pay back the amount with interest. However, when considering a 401(k) loan, you’ll want to understand how it works and the potential complications.
Follow these steps before borrowing funds from your 401(k) plan:
Know how much you can borrow. Some 401(k) plans allow you to take out a loan while others do not. Start by checking with your plan’s administrator to learn if borrowing is an option. If it is, find out the limits for the loan. “Typically, you’re allowed to borrow up to 50 percent of your account balance or $50,000, whichever is less,” says Eric Meermann, vice president of Palisades Hudson Financial Group in Stamford, Connecticut.
Understand how a 401(k) loan works. Unlike other loans, you won’t need to involve a lender or have a credit check when borrowing from your 401(k). “You can access your account without paying tax or penalties, as long as you pay back the loan on time,” Meermann says. Your plan will determine the interest rate on the loan. In most cases, the rate is based on prevailing industry rates. The interest rate for a 401(k) loan will often be lower than what you would pay for credit card bills and other high interest debt. You’ll also need to follow a repayment schedule, which is generally five years. If you use the loan to make a down payment on a home, you might have a longer time to pay back the loan, such as more than 10 years.
Be aware of penalties for missed payments. If you take out a 401(k) loan and are unable to pay it back on schedule, the costs are steep. “The penalties for 401(k) [loans] are some of the harshest out there,” says Russell Robertson, founder of ATI Wealth Partners in Atlanta. Missed payments are considered withdrawals from the plan. This means you could owe taxes on the amount withdrawn and pay a 10 percent penalty for withdrawing early if you are under age 59 1/2. “That’s potentially a total penalty of 25 percent to over 40 percent, depending on your tax bracket and age,” Robertson says.
Evaluate the need to borrow funds. While you likely won’t want to tap your retirement account for a vacation or new entertainment system, there are times when it might make sense. “It can be a good move if you need the money for a serious purpose, such as a home down payment or to pay down high interest debt,” Meermann says. If you’re facing an expensive emergency, a 401(k) loan might be a smarter move than running up credit card debt. To pay off school debts or cover educational expenses, a 401(k) loan might offer better rates than other types of loans.
Consider other options. If you own a home, a home equity loan might offer more favorable terms. Home equity loans generally have low interest rates and a longer payback period. “Another option for a short-term loan is credit cards, if you can take advantage of a 0 percent APR introductory offer,” Robertson says.
For health care expenses, talk to your employer about financial assistance. “Ask your employer if they offer a program like MedPut that that allows you to finance your out-of-pocket costs through payroll deductions,” says Laurie Brednich, CEO of HR Company Store.
Certain emergencies might make a hardship distribution a better option than a loan. You’ll need to meet specific criteria regarding immediate and heavy financial costs, such as facing eviction from your home or foreclosure, burial or funeral expenses, or certain medical expenses. Before taking a distribution, keep in mind that unlike a 401(k) loan, a distribution cannot be paid back.
Think about your career plans. If you plan to stay with your company for the next few years, you’ll likely have time to pay back the loan. If you’re thinking of switching jobs, the repayment schedule could get interrupted. “If you still owe money when you leave your job, you will need to repay the balance in full within a short grace period,” Meermann says.
Know how you’ll pay it back. In most cases, your employer will set up automatic deductions from your paycheck as you pay back the loan. This is usually done each month, so you’ll want to look over your current budget. Spot areas where you can reduce other expenses to avoid going further into debt.
Be aware that it might be difficult to continue to set aside funds for your 401(k) plan while you repay the loan, and you could miss out on company match benefits. “Many employers do not apply the company match to loan repayments,” Brednich says. Your 401(k) plan may not allow you to make further contributions while you are paying back the loan. Even if it does allow you to continue with contributions, your company might not match any of your contributions during the repayment process.
Recognize long-term risks. When you borrow from your 401(k), you could miss out on future growth for your retirement. “Taking money out of a plan impairs the ability for the assets to grow and compound,” says Eric Nager, an investment advisor at Southern Capital Services in Daphne, Alabama.
You’ll also want to consider the possibility of losing high market returns. “If you’re mainly invested in stocks, the average annual expected return hovers around 10 percent – more than the typical interest rate on borrowing from your 401(k), currently around 3 percent,” Meermann says.
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