Thinking about a 401k loan? A 401k is meant to fund retirement, but you can withdraw money from it earlier. It goes against personal finance philosophy to take money out of a retirement account before retirement, but under the right circumstances, it is something to consider.
A 401k Refresher
By now most of you know what a 401k is but for those new to the site, this will get you up to speed. A 401k is an employer-sponsored retirement account. Employee contributions are deducted directly from your paycheck before they are taxed.
The money is invested in one of the funds offered by the employer. If you’re lucky, your employer matches your contribution. This is free money. For the year 2017, you can contribute up to $18,000.
Because that money is meant for retirement, withdraws are discouraged before you reach age 59 ½. If you withdraw money before that age, you will be hit with a 10% penalty. There are some exceptions.
If you are no longer working at age 55, if you are using the money to pay medical expenses, or if you have become disabled for example, you can withdraw the money penalty-free.
There are lots of good reasons to invest in a 401k. Not many people get a pension anymore so a 401k may be their only retirement plan. There is also a low bar to invest in a 401k. Your employer does the work; you just have to opt-in. You don’t have to know anything about investing to get started.
Contributions are taken directly from your paycheck, so you never have a chance to spend the money. For some people, this is the only way they will save for retirement.
The money goes in and grows tax-free. This can help reduce your taxable income and bump you down to a lower tax bracket. When you retire and need the money, most of us will be in a lower tax bracket than we were during our working years, so that is a tax saving. A 401k can also be a great place to borrow money from.
How it works
Borrowing against your 401K means, you are borrowing from yourself. Unlike borrowing from a bank, the interest you pay, you pay to yourself. The amount you borrowed is no longer invested so rather than getting investment gains; your “gain” is the interest you payback.
You can borrow up to $50,000 if you have a vested balance of at least $100,000 or 50% of the value, whichever is less.
You indicate the account you want to borrow money from. Those investments will be liquidated. You will lose any gains those investments might make during the duration of the loan. Depending on the plan rules, you may or may not be allowed to continue making pre-tax contributions.
You have five years to pay back a 401k loan, then if the loan was used to buy a home that will be used as your primary residence. There is no early repayment penalty. Most plans allow you to repay the loan through payroll deductions, the same way you invested the money.
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Good Reasons to Borrow Against a 401k
If you need money fast and for a short period, a year or less, borrowing from your 401k can be a good solution. You’ll have the money quickly sometimes within a few days, and the process is convenient. Some plans allow you to do everything online.
The cost will be low, you usually just pay a small origination or administration fee. You won’t have to go through a bank, so you avoid all the paperwork and credit checks. Borrowing from your 401k has no impact on your credit.
Borrowing from your 401k for a home purchase whether it’s a home to live in or a rental property, can be a good investment. Primarily if you can use the money for a bigger down payment because that reduces the amount of long-term interest you will pay on your mortgage and can help you avoid PMI.
It’s a similarly good option if your credit score is too low to get a reasonable interest rate on loan.
Refinancing credit card debt is another good reason to borrow against your 401K because you’re paying yourself back at a much lower interest rate than you’re paying to a credit card company.
Borrowing money from your 401k for educational expenses can also be worthwhile. You can avoid taking on student loan debt, and additional education can improve your career prospects.
Bad Reasons to Borrow Against a 401k
If you’re borrowing money for ordinary expenses that should be part of your budget like mortgage or rent payments you have a spending problem. These are not unexpected expenses; they are what it costs to live your life. You either need to spend less money or make more, ideally both.
Your 401k is also not an emergency fund. You should have at least $1000 in an emergency fund and ultimately six month’s worth of expenses. That is the money you use for an unexpected expense like a significant car or home repair.
Your 401k is not a source of discretionary spending. Do not pay for things like a vacation or a house full of new furniture. Those are things you have to save up for. Your 401k isn’t savings; it’s retirement savings.
Myths About Borrowing Against a 401k
There is a lot of fear-mongering about borrowing from your 401k and for a good reason. Not everyone who does it would make good use of the money by investing in a home or an education.
If borrowing were not discouraged, too many people would raid their account for silly reasons that will hurt their retirement savings.
But not all of the doom and gloom is entirely true. Borrowing from your 401k is not necessarily damaging to your retirement savings. When you pay the loan (yourself) back, the payments go back into your investments. Because you’re paying interest, you’re paying back a little more than you borrowed, so you’re putting additional money into the account.
As long as any interest payments are the same or greater than what you lost during the time that money wasn’t invested, your savings aren’t affected and can increase if the interest is more than any earnings losses.
Another myth is that when you borrow from your 401k, you are being taxed twice because you’re paying the loan back with after-tax money.
But in truth, only the interest part of the repayment is treated that way. And being twice taxed on interest from this kind of loan is likely to cost less than what it would cost to borrow money in another way.
The biggest fear that surrounds borrowing from a 401k is what will happen if you leave the job either voluntarily or involuntarily. If it happens, you are required to pay back the loan in full within 60 days.
This understandably freaks people out. Ideally, you won’t borrow against your 401k if you feel that you are in danger of losing your job or you plan to leave shortly. If your job is stable, this fear is mostly unfounded.
Of course, all of us are expendable. What if you do lose your job and have to pay the money back?
Well, we don’t have debtor’s prisoners anymore (for now), so it’s not like you’ll be locked up. What will happen is that the IRS will classify the remaining balance as an early withdraw and with a few exceptions, hit you with a 10% penalty on that amount and require that you pay taxes on the distribution.
So, Should You Do It?
There indeed can be negative consequences if you borrow from your 401k but they are not as dire as we have been led to believe. If you use the money to make or save money as you could if you were to use the money to buy a rental property or to pay off high-interest credit card debt, the payoff is worth it.
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