Read This Before Taking Out a 401(k) Loan

At some point in your life, you’ll need to borrow money. Whether it’s for a new home, college tuition, medical bills, or even launching a new business, the need for extra cash will inevitably arise. The good news is that several lending options are readily available: you can borrow from banks, credit unions, credit cards, peer-to-peer lending platforms, family, and friends.

However, another loan option worth considering is your 401(k) account. Before you take the plunge, you should know how 401(k) loans work and the pros/cons of borrowing against your 401(k): which is precisely what this post will cover.

Identifying if you have a 401(k)-loan option

If you participate in a 401(k) and your plan offers loans (over 90% in fact do), your plan administrator can provide information on how to apply. Most employers also allow you to borrow from your 401(k) for any reason; however, it’s best to check with your HR department for specifics regarding your individual plan.

How much you can borrow from your 401(k)

By law, the maximum loan amount you can borrow is generally 50% of your vested account balance or $50,000: whichever is less. If your vested balance is $50,000, you can borrow up to $25,000.

Pros of borrowing from a 401(k)

Like any other type of debt, taking out a 401(k) loan offers some advantages. These include:

· Convenience: Often, a quick phone call is all that’s needed to receive funds within a few days (depending on your plan administrator). Loan payments are also generally deducted from your paycheck, making repayment easy.

· No credit reporting: A credit check isn’t required when applying since there is no underwriting, and your 401(k) loan won’t appear as debt on your credit report. You also won’t damage your credit score if you miss a payment or default on your loan.

· Low interest rates: Typically, the rate on a 401(k) is lower than what you can obtain through alternative sources, making your payments more affordable.

· Interest paid back: With a traditional loan, you pay interest to a financial institution. With a 401(k) loan, the interest you pay goes back into your account.

· Payment flexibility: You have five years to repay your loan (or up to 10 years when the money is used to purchase a principal residence) and face no prepayment penalties.

· Suspended and/or extended payments: If you’re in the armed forces, you may be able to suspend your loan repayments and/or extend your term if you’re called up for active duty.

Cons of borrowing from a 401(k)

On the flip side, taking out a 401(k) loan also involves several risks. These include:

· Missed investment growth: When you take out a 401(k) loan, that money is no longer invested. Consequently, you can potentially miss out on significant investment returns: especially during a bull market.

· If you leave your job, you’ll need to pay back your loan quicker: Whether you leave your job voluntarily or otherwise, you may be required to pay back your loan within 60 days.

· Defaulting means potential taxes: If you can’t repay your loan, your loan balance is considered a “deemed distribution” and you can be taxed by the IRS and assessed a 10% penalty if you are under 59 ½ years old.

· You may face a denial: If you are nearing retirement, you may be deemed a higher risk and thus denied a loan because payments will no longer automatically come out of your paycheck. Other reasons for a denial include exceeding your loan limit, your plan allows for only one loan at a time, or your reason for seeking the loan doesn't meet plan criteria (i.e., you want to use the funds to finance your next vacation).

· 401(k)s from previous employers don’t count: Unless you rolled over money from previous 401(k)s, you can only borrow money from your current 401(k) plan.

· You may contribute less: Once you obtain a 401(k) loan, it’s not uncommon for plan participants to also scale back their contributions. In some cases, employers may not allow for contributions while participants have an outstanding loan: meaning you can also miss out on matching contributions from your employer.

As you can see, borrowing from a 401(k) has many drawbacks—which is why you’ll often read reasons why you should only consider this as a last resort.

401(k) loan alternatives

In addition to your checking, savings, and brokerage accounts, you should first consider 401(k) loan alternatives.

A home equity loan or line of credit is sometimes a low-cost option to meet your cash needs, especially if you need the funds to pay for much-needed home repairs. Plus, the interest in either solution is often tax-deductible.

Another option is to take out a personal loan, providing you with quick access to funds and the ability to use the money for any personal expense. As with any loan, make sure you shop around for the best deal if you decide to go this route.

On a more granular level, you can use a health savings account (HSA) to pay for qualified out-of-pocket healthcare expenses including deductibles and copays. If you need cash for a qualified medical expense, an HSA can help in this regard.

If you can repay your balance within the promotional period, a low or zero-rate credit card may provide a viable alternative. Promotional periods typically range from six to 18 months, depending on the issuer.

In sum: taking out a 401(k) loan

Contemplating whether or not to take out a 401(k) loan is a decision to not take lightly, as the risks generally outweigh the benefits. However, that’s not to say a 401(k) loan never makes sense. If you’re on track for retirement and don’t anticipate any job changes, a 401(k) loan is often the right move. Speaking to a CFP® professional is an even better one.