You’d pay interest to yourself, effectively contributing more money to your retirement plan. But there are a few considerations you keep in mind before taking a loan from your retirement account. There’s a maximum amount you can take out, and a repayment period must be met.
The Positive Aspects of 401(k) Borrowing
The whole point of a 401(k) is to put away money that you won’t touch until retirement but taking a loan from your plan might be your best option under certain circumstances. A high-interest title loan, a credit card cash advance, or even a more reasonable personal loan can still cost more than double the interest you’d pay on a 401(k) loan. There are a few redeeming factors that can make these loans sensible under certain circumstances and if you know you’ll have the means to repay the loan within a short term, The designers of the 401(k) plan have the option to include the ability for you to take hardship distributions, which allow for withdrawals from the account for defined hardships, such as emergency medical expenses or mortgage payments.
The Downside of 401(k) Loans
There are a few major catches to a retirement account loan. Your retirement plan assets, such as a 401(k), 403(b), traditional IRA, Roth IRA, simplified employee pension (SEP) IRA, or SIMPLE IRA, would be protected if you should ever find that you have to declare bankruptcy. They’re safe havens or lockboxes that creditors have a very hard time touching. That money becomes available to creditors after it’s taken out of the account in the form of an outright withdrawal or a loan.
Not All 401(k) Plans Let You Take Loans
The law allows companies to offer 401(k) loans in their plans, but companies aren’t required to do so. In fact, some employers oppose the idea of 401(k) loans because management or owners believe that retirement assets in these accounts should be held beyond reach and out of the way of temptation. Some employer plans only permit 401(k) loans for specific purposes. A number of people who had been living with too much debt found themselves unable to make credit card payments or pay their mortgage during the Great Recession of 2008 and 2009. Many decided to take a loan until they found out that their company plan didn’t offer 401(k) loans for that very situation, to prevent people from losing their retirement assets when markets fluctuate and cause other losses.
The Maximum You Can Borrow
The biggest 401(k) loan you can take is equal to 50% of your account balance or $50,000, whichever is less, even if you have millions of dollars in your retirement account. There are no exceptions. It can make more sense to use your savings than to withdraw from your retirement plan and lose the opportunity for it to earn more money for you.
The Interest Rate on Your Loan
You must pay interest when you’re repaying money borrowed from your retirement plan. It’s typically the prime rate plus 1% to 2%. You’re paying the interest to yourself so it’s something of a transfer from one pocket to another rather than a real expense, but you still have to come up with the cash.
The Repayment Period for 401(k) Loans
You’re required to repay the money, with interest, over a period of 60 months when you borrow from your 401(k) account. That five-year period can be extended for those who use the borrowed money to purchase a primary residence, but the terms of a 401(k) loan aren’t going to be nearly as attractive as those of a traditional mortgage loan from a local bank in most cases.
Consider a 401(k) Loan Very Carefully
A 401(k) plan can be a great way to save for retirement by building wealth through years of tax-advantaged compounding but removing money from the account early through a loan can really cost you. This is the case even if you intend to repay the funds. Review all the pros and cons as they pertain to your specific situation and speak with your financial advisor before making your final decision.
