For many people, it is possible to borrow against your 401k retirement account. Just because it’s possible, doesn’t make it the best option for everyone. When you borrow from a 401k plan, you end up repaying yourself, plus interest – but it’s not quite as simple as that sounds.
photo credit: slworking2
Basic 401K Loan Borrowing Rules
Each plan has slightly different rules as they are managed by the plan administrator – usually your employer.
Most 401k plans allow for loans. You must first check with your plan administrator to see if the plan allows loans – if they do not, you will not be able to borrow from your account. If they allow loans, then you can borrow up to 50% of your total account balance or $50,000 (whichever amount is less).
For most 401k loans, there is a maximum of five years to repay the loans, unless you use the money to pay for your first house, in which case the plan will allow a longer repayment term.
There are no credit checks to qualify for a 401k loan. There is no “application” process like there is when you go to a bank or credit union for money. The money is yours, and although it’s meant to be used for retirement, if the fund allows for 401k loans, you can take one if that’s what you choose to do.
The plan will set the interest rate, which is almost always lower than an interest rate you pay to a bank or credit union. The interest you pay is usually a couple percentage points more than the prime rate.
Unlike a “hardship withdrawal”, which requires certain financial situations to qualify and charges a 10% penalty as an early distribution of your retirement fund – a 401k loan does not charge a penalty since you will be paying it back.
Why You Should Think Twice Before Borrowing from a 401K
While it seems like borrowing money from a 401k plan is a great way to get some cash when you need it, there are a number of reasons to think twice before signing your name on the dotted line.
It’s true that you’re borrowing money and paying yourself back with interest – but it’s also true that you have less money in your fund to invest and earn interest. The money taken out for your loan is no longer appreciating in value and you miss out the benefits of compounding interest.
Once you start making payments to your 401k for a loan, the payments are made with after-tax dollars. When you take the money out again in retirement, you’ll have to pay taxes on the money again. When you contribute to a 401k normally, the money goes in before taxes are taken out, and the taxes are paid when you withdraw the money during retirement.
Once you start taking loans from your 401k, your frame of mine about saving for retirement changes. The point of retirement plans like a 401k is to save the money until you are ready to retire. The more frequently you take money from the account, the less you will have when you retire.