The Pros and Cons of 401k Loans

by James on January 8, 2013 · 1 comment

401k-loansHi All,

Last week I was talking with a friend of mine, who had decided to take a loan against his retirement to refinance an expensive mortgage he had. My friend ended up saving like $400.00 a month on the deal.  That got me thinking, so I decided to do a posting on 401 (k) loans for those interested in exploring these kinds of deals. He’ll be able to repay the loan in a matter of months with the savings and continue to benefit for the life of his mortgage.  Not a bad deal, if you ask me.

So, if you are employed you may be enrolled in a 401(k) or 403(b) retirement plan. If you have one of these plans, you might be able to borrow against the balance of the account.  That said, it’s not free money and there some things you need to know.

1) Borrowing Limits:

In general, you can borrow the lesser of $50,000 or one-half of your retirement plan balance. If the value is less than $20,000 your plan may allow you to borrow as much as $10,000 even if that represents the total value of your balance. If you accept the loan, you must typically agree to begin paying back the debt during your next pay period.  Often this is done via direct debit from your bank account.

2) Loan Length Restrictions:

Unless you use the money to acquire a home, you typically must pay the loan back over five years or less.  If you borrow the money so you can purchase a residence, the length of the loan may be significantly longer, but there is some risk if you lose or quit your job.  But, basically you’ve got 5 years.

There are several advantages and disadvantages of 401(k) loans.

First, the advantages:

1) 401(k) Loans Do not Require A Credit Check:

No credit check will be performed if you request a 401(k) loan since you aren’t actually borrowing money.  Instead, you are temporarily tapping your retirement funds. Since you are technically borrowing from yourself, there is no need to check your credit.   This is to your advantage because shopping for loans can be hard on your credit if you have too many checks on your record.

2) You Pay Interest To Yourself:

Regardless of your credit score, you’ll pay a competitive interest rate.  The rate is set by your plan sponsor but is often prime or thereabouts.  As noted, you’ll be paying the interest to yourself, which is pretty sweet.  The entire amount of each loan repayment goes back to your 401(k) account – there won’t be any bankers taking a big cut.  Fees are typically pretty low as well.  Most of the time you only have to pay a couple of hundred dollars to make the loan happen.

3) Ability to Access Your Capital:

One great thing about 401k loans is they allow you to access your savings.  This is key as the long term process of building wealth involves both savings and investing.  If you want to make an investment in a small business, or leverage your stock portfolio, the opportunity to get at your savings can have a potentially large and favorable impact on your wealth building.  For example, you could borrow to increase your cash flow, improve your diversification, or refinance higher interest debts.  Additionally, if you have a financial emergency, you could borrow to meet expenses.

Second, like any financial product, 401k loans have some potential downsides.

1) 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 forego all potential investment gains from all borrowed funds for as long as the loan is outstanding.  So, essentially your money isn’t on the stock market working for your retirement.  This could have a potentially large and negative effect in that you’ll lose any potential gains you could have made in the markets, though at points in the market you may be happy to have those funds out of play, so this depends on movement within the market.

2) Negative & Potentially Negative Tax Impacts:

When you pay back your loan, you do so with post-tax (after-tax) dollars.  For example, a $200 loan repayment reduces your take-home pay by $200.  Also, if you don’t fully repay the loan by the time 5 years is up (assuming you are younger than 59 and a 1/2), you have to pay a 10% penalty on the unpaid balance to the IRS.  This because the IRS will additionally treat whatever money isn’t repaid as an early withdrawal from your retirement account, which means you have to pay regular income taxes plus fees on it.

3) You Could Lose Employer Matching:

Another potential downside to 401k loans is you could lose your employer match. If you take a 401k loan, your employer may end their contribution while you are withdrawing your loan.  This also means less money for your retirement.  It also undermines one of the major advantages of 401ks – which is free money from your employer.

4) Risk of Job Termination:

No matter the cause, if you cease working with your current employer, your entire loan is usually due between 60 and 90 days after your date of termination.  If you can’t pay back the loan balance in that quick of a time frame, the entire amount you are unable to pay is deemed a distribution by the IRS, which is subject to the 10% early withdrawal penalty.  So, basically you gotta hang onto your job, otherwise the IRS could take a big chunk.

5) Be Cautious:

It is a must to think things through and make sure you have a well thought out plan for repayment and that what you will use the funds for are worthwhile cause to borrow against your 401(k).  Blowing your retirement funds and not having a plan to get back on track is to be avoided.

If you are looking for a good way to evaluate whether a 401k loan is for you, check out bankrate.com’s 401k calculator.  It gives you a good sense of the opportunity costs involved in borrowing from your retirement.

Best,

James



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